How Do Forex Brokers Work?

Ever wondered how forex brokers work? How they make money? To answer these questions, you need to understand the different types of forex brokers and their various business models. Unlike humans, not all forex brokers are created equal. Some are much more competitive than others and some, are just outright scammers. Sadly it’s not always easy to tell the difference between the two, some of the oldest and most famous names in forex are notorious for shady and underhanded tactics. In this article we will discuss the various types of forex brokers and why it’s important to trade with a true ECN broker.

Market Makers and Spreads

All forex brokers will tell you they make their money off the spread (the difference between the buy and sell price), however lots of brokers actually only derive a small portion of their income from spreads. How do they make money then you ask? Simple. By trading against their clients.

These brokers are known in the industry as market makers. The problem is, the vast majority of forex brokers actually operate in this manner. When you first start out trading you assume you are buying and selling from other participants in the market: if you make money, someone else is losing money and vice versa. This is true to a point, but often this ‘someone’ is a lot closer than you think … it’s your broker!

The vast majority of new traders lose money, that’s a fact. If they continued to trade and addressed shortcomings in their strategy and psychology, they would likely improve and end up becoming profitable, but many just aren’t up to the challenge and leave as losers. Market makers are not only fully aware of this, their entire business model revolves around it. Market makers make money when their clients lose, simple as that. This is a glaring conflict of interest, rather than the broker making money when the client wins and continues to trade, they actually have a vested interest in their client losing!

The market maker game is to recruit new traders by the hundreds, offer some free, substandard education, or a bonus. Even if the new trader is lucky to begin with and makes money off their bonus, they will likely then make a much larger deposit which they eventually lose.

Because of the inherent conflict interest involved in making a market, some (though not all) market makers have been known to engage in some extremely nefarious tactics. There are horror stories of unexplainable spikes, spread widening, stop hunting and even refused withdrawals and closed accounts!

STP Forex Brokers

STP is short for Straight-through Processing, STP brokers essentially operate on the model you thought your market making broker used: they make their money off the spread and you are actually trading against other participants in the market. STP brokers aggregate prices from their liquidity providers and add a small markup, you place your order with the broker, the broker passes the order on to their liquidity provider (retaining the small difference in spread). Because you are trading against other participants in the market and not your broker, STP brokers have no interest in you losing. In fact, if you lose money and stop trading, then you are no longer earning your broker money.

The STP model is a huge step up from the market maker model and Vantage FX offers this model to all clients on our standard accounts with a minimum first deposit of only $100. Even so, many professional traders and scalpers find the third brokerage model to be cheaper: true ECN.

True ECN Forex Brokers

True ECN is the logical conclusion of the STP model and is favoured by the vast majority of professional and high volume traders. As far as execution is concerned, the model is almost identical to STP: you are trading against other participants in the real forex market and not against your broker. The primary difference between STP and true ECN is that ECN brokers don’t make their money off spreads, but instead charge a small flat commission charge on each trade. There is zero spread mark, the spreads offered on true ECN accounts are razor sharp, often as low as 0 pips. These are very best prices available in the real forex market right at the time. Razor-sharp, zero mark-up spreads and transparent fixed fees make ECN accounts the favoured option for scalpers, professional traders and traders running automated systems that are adversely affected by wider spreads.

Just like the STP model, there is zero conflict of interest between the trader and broker when trading on a true ECN account. Your true ECN broker wants you to succeed in trading, grow your account and begin to trade size. The more size you trade, the more your broker makes. This is the way it’s supposed to be, with the broker and client’s interests in perfect alignment.

ECN accounts were formerly only available to high net worth and institutional clients, but over the past few years traders have become more savvy and there has been increasing demand for the best deal from retail clients.

So now you know …

We hope you have enjoyed this piece on the different types of forex brokers and how they work. In summary, market makers are the most expensive option for trading and actually make money when their clients lose, bad spreads are only part of the story, some traders have experienced a lot worse! STP brokers on the other hand are a huge step up and a great option for traders who are just getting started on their trading journey. When it comes to serious professional trading, scalping or automated trading though, there is only one option: ECN.