The Many Faces of Forex Brokers

Forex (Foreign Currency Exchange) traders invest a lot of time wringing their hands and discussing their various uncertainties regarding the retail brokers they use to handle their money. It's understandable to presume that trying to make money with Forex merely means to 'beat the market' by identifying and making good quality trading opportunities. In truth, there is much more to it; the broker which is honoring your trades can greatly impact how successful you are.

Bucketshops are agencies who take unfair liberties with their own clients by taking positions against their clients and even by falsifying the price values they quote. This policy (although the majority attempt to deny that) sets up a moral problem that always benefits them and to the detriment of their clients. The appellation 'Market Makers' is also regularly used to describe certain brokers who commonly assume the other half of their own clients' positions. They are creating the market that their customers are trading in, instead of simply relaying those orders out to the broader market. A truthful examination of the environment of currency, however, reveals that this practice is actually essential to allowing small retail trades to happen, and although it can be.

The reason this is true is due to the fact that there is no real 'Forex market', like there is for typical varieties of trading. As an example, commercial stocks are traded only by way of traditional stock exchanges -- the NYSE being one of the biggest. Exchanges such as these are regulating bodies that qualify every company to be traded, define the specifics of the standard trading contracts, monitor brokers, and finally clear every trade financially. Stock exchanges establish the daily hours for trading and have the responsibility to decide if any stock or trading agency should be removed or suspended because of practices which might damage the broader market. These exchanges have actual physical addresses and are themselves monitored by governmental agencies.

By contrast, the Forex market is merely the totaled trading of corporations that want to convert money from one particular currency to another. They are major institutions; financial groups and giant conglomerates which desire to convert capital from one currency to a different one so that they will be able to trade goods from one nation to a different one. Suppose a company located in Australia markets its products to Canada. The payment will be received in the form of Canadian Dollars, but the business will have to pay for its expenses in Australian Dollars. It will need a convenient means to convert its capital virtually each business day. Businesses such as this and the banks they use to change the currency are the true market, and small time traders are not able to trade at this level; we just don't have the large amounts of capital that would be of interest to the real currency players.

Because of this a Forex broker must be free to trade currency directly with their customers. These brokers can accept smaller trades of the variety we can do, and then they just lump them all together. They then do more substantial offsetting trades on the open market by way of agreements ironed out with 'Liquidity Providers'. The major banks are able to make trades with a broker who represents many individual traders despite the fact that they would not ever think of trading with each and every individual. It just wouldn't be possible for them.

And so, a retail broker must provide price values to its clients, but there's no official exchange which sets the prices traders are given. Each broker has to start with quotes provided to it by its liquidity provider(s) which might not be in tune with those given by other banks. That's the reason why two different agencies almost never quote exactly the same prices. From this truth comes the need for a brokerage to make the market for its customers, not necessarily from a penchant to screw them (though some few most likely do). A broker could be ethical yet still need to trade opposite its clients, even if they're not attempting to falsify price quotes and cause those clients to lose.

So, to sum up, we have seen that many retail brokerages are required to take an opposing position for all but the biggest of their clients' positions, however they should not take advantage of this to unethically work to their detriment. This creates a critical condition of 'caveat emptor' - or let the customer be careful. All traders and those who want to learn forex should carefully select their broker and must diligently monitor the trade and price activities to see that they are being treated in an equitable way. In fairness, however, every customer ought to recognize that the brokerage is forced by circumstances to trade opposite to them and they shouldn't presume a heinous motivation. It's an inescapable, though somewhat distressing aspect of the retail Forex business model.

B. Keith Dalton has been studying and trading Forex for years, using his knowledge and experience in the realms of science, engineering, computer programming and statistical data analysis to help him understand the often confusing and chaotic world of Foreign Currency trading. He has made it a personal goal to help fellow traders by sharing his insights and understanding to de-mystify the Forex market experience.
You can read his blog at Money Pipeline. He writes and sells Forex indicators and trading systems at www.tantalusonline.com.