How Do Forex Brokers Work?

To answer the questions of how forex brokers work and make a profit, you need to understand the various types of forex brokers and their business models. Not all brokers are created equal. Some are more competitive than others and some, unfortunately, are just outright scammers. Alas, it is not an easy task to tell the difference between the two and even some of the oldest, most well-known names in forex are notorious for shady antics. Below are some of the types of forex brokers.

Market Makers and Spreads

Forex brokers will tell customers that they make profits off the spread (which is the difference between the buy and sell price), but many brokers actually only generate a small portion of their revenue from spreads. In reality, they actually make money by trading against their clients.

These brokers are called “market makers,” and the vast majority of forex brokers operate like this. When you start out trading, you assume you are purchasing and selling from other market participants. You think that if you make money, someone else is losing it and vice versa. While somewhat true, this ‘someone’ is actually your broker.

The vast majority of novice traders end up losing money. If they persist in trading and correct flaws in their trading psychology and strategy, they are likely to improve and make money. However, many aren’t up to this challenge and leave the game as losers. Market makers are not only very aware of this occurrence, their whole business model revolves around it. They make money when their clients lose it, creating a rather glaring conflict of interest. Instead of making money when their client wins and continues trading, a broker actually has a vested interest in him or her losing.

A market maker’s purpose is recruiting new traders by the hundreds by offering free, substandard educational tools or bonuses. Even if a new trader starts out lucky, he or she will make a much larger deposit that they will eventually lose.

Due to the conflict of interest involved market making, some (though not all) market makers have been known to engage in some underhanded tactics. Horror stories abound about spread widening, unexplainable spikes, stop hunting, closed accounts, and even refused withdrawals.

STP Forex Brokers

STP is the acronym for Straight-through Processing. These brokers operate on the model your market making broker conned you into thinking it used. STP brokers make their money off the spread. You are actually trading against other market participants. These brokers aggregate prices from liquidity providers and add a minor markup. You place your order with a broker, who passes it on to its liquidity provider while retaining a small difference in spread. Because you’re trading against other market participants and not your broker, STP brokers have no desire to see you lose. If you lose money and quit trading, STP brokers lose as well.

STP’s model is a step up from the market maker model. However, many professional traders and scalpers find the third brokerage model true ECN, to be cheapest to use.

True ECN Forex Brokers

True ECN is the STP model’s logical conclusion. The vast majority of professional and high volume traders favour it. The true ECN model is almost identical to STP. With true ECN, you trade against other participants in the forex market; you do not trade against your broker. The main difference between STP and true ECN is that the latter doesn’t make a profit off spreads. Instead, it charges a flat commission fee on each trade. There is no spread mark, and the spreads offered by true ECN accounts are sharp, typically as low as 0 pips. These ECN prices are the very best available in the forex market. Razor-thin, no-mark-up spreads, transparency, and fixed fees make ECN the favourite option for professional traders, scalpers, and traders operating automated systems that are negatively affected by wider spreads.

As with the STP model, there is no conflict of interest between trader and broker when they trade on a true ECN account. This broker wants you to succeed, grow your account, and trade sizably. Your broker makes more money when you trade more size. The broker and client’s interests, with this model, are in perfect alignment.

ECN accounts, at one time, were only available to institutional clients with a high net worth. But, throughout the past few years, traders have become savvy and demanded better services from retail clients.

So now you know …

To summarize, market makers are the most costly option for trading because they actually make money when their clients lose. With market makers, bad spreads are just part of the story, some traders have experienced even worse horror stories. STP brokers are a huge step up from market makers. They are an excellent option for traders who are just getting going on their trading journey. For scalping, serious professional trading, or automated trading, however, ECN is the best option.