Hello, lucashier
There are two major differences between the [B]dealing-desk (DD) broker business model,[/B] and the [B]non-dealing-desk (NDD) broker business model:[/B]
(1) the way retail prices are determined, and
(2) the execution method (that is, what happens after your position is opened).
[U]Dealing-Desk (DD) Brokers[/U]
B Pricing[/B]
Wholesale bank prices (prices offered to retail brokers by liquidity providers in the interbank network) are marked up by DD-brokers to yield retail prices, which are then offered to retail customers (meaning you and me). The mark-up is normally determined mechanically by a computer algorithm which factors in such things as market volatility, in order to provide the DD-broker with a desired level of profit.
Example: the bank offers the DD-broker a 1-pip spread on a particular pair, and the DD-broker adds a pip (or more) to each side of the bank’s wholesale price quote, offering their retail customers a 3-pip (or higher) spread. For instance, bank’s prices (BID and ASK) 1.5024/25; DD-broker’s prices (BID and ASK) 1.5023/26.
Bank spreads are not fixed — they can, and do, change in response to market conditions.
Similarly, the DD-broker’s retail mark-up can change — often in tandem with changes in the bank’s wholesale spread. These changes can be rapid and large, especially when major economic news is due to be released.
If a broker offers “fixed spreads”, it’s a sure sign that the broker is a DD-broker. Such spreads are possible only if the retail mark-up is large enough to cover the market risks (volatility, etc.) anticipated by the broker. When market conditions exceed the range which the “fixed spreads” can cover, brokers who offer such spreads typically resort to re-quotes and slippage to fend off unprofitable customer orders.
B Execution[/B]
When a retail customer opens a trade with a DD-broker, that broker is immediately put into a position (opposite to the customer) in which he (the broker) has market exposure.
Example: You open a LONG position in a particular currency pair; your DD-broker immediately acquires an equivalent SHORT position in that pair, because he takes [I]and holds[/I] the other side of your trade.
How long your DD-broker holds onto the other side of your trade determines the extent of his market exposure (to price movement in the pair you are trading), and ultimately determines whether his side of your trade produces a profit or a loss for him.
He might believe that you have entered the wrong side of the market, which means that you probably will suffer a loss. In this event, your loss will become your DD-broker’s profit. In order to capture this profit (from your loss), your DD-broker might choose to hold onto his side of your trade.
This creates the potential for a conflict of interest between you and your DD-broker, because he controls the BID and ASK prices on which your trade either survives or gets stopped-out. If you get stopped-out, your DD-broker — who has held onto his side of your trade — banks the profit which is the flip-side of your loss.
It is possible for a DD-broker to (1) use a market-sensitive formula (algorithm) for adding mark-ups to wholesale bank prices, but then (2) remain “blind” to the profit/loss position of his customers, thereby eliminating the possibility of manipulation of the BID or ASK price for the express purpose of making retail customers lose.
Oanda claims to operate exactly this way. Oanda readily admits to being a retail market-maker (which, most traders would say, is another name for a DD-broker), but Oanda claims “no dealing-desk intervention”. You have to read their explanation in order to parse that terminology. But, in short, it means that their algorithm determines retail mark-ups to the bank’s wholesale BID and ASK prices, and then Oanda maintains a “firewall” between their dealing-desk (the algorithm) and their customers’ accounts, precluding any manipulation of prices for their own gain.
A DD-broker who does not want to be exposed to the market risk associated with holding the other side of his customer’s trade can offset that risk by placing an identical trade upstream with the bank.
Example: You enter LONG one lot of USD/CAD, placing your DD-broker in a SHORT position, which he doesn’t want. He can enter LONG one lot of USD/CAD (trading with the bank), thereby reducing his overall market exposure to zero. He still holds the other side of your trade, but his side is offset (hedged).
[U]Non-Dealing-Desk (NDD) Brokers[/U]
B Pricing[/B]
Wholesale bank prices are passed directly to the NDD-broker’s trading platform, where they are offered to retail customers, [I]without a mark-up.[/I] A commission is charged by the NDD-broker as his compensation for the service he is providing. In this model, the customer’s transaction costs are (1) the bank’s spread, and (2) the NDD-broker’s commission. The bank’s profit is the bank spread, and the NDD-broker’s profit is the commission.
Bank spreads can widen (or narrow) due to market conditions, as in the DD model, above. But, the variation in [I]retail[/I] spreads is not nearly as great in this (NDD) model, as in the DD model, above.
In the NDD model (bank pricing + commissions), customer transaction costs, averaged over time, are generally equal to, or lower than, transaction costs in the DD model (bank pricing + retail mark-ups).
B Execution[/B]
When a retail customer opens a trade with an NDD-broker, that broker simultaneously opens an offsetting trade with the bank, such that the NDD-broker’s net market exposure is zero. When the retail customer’s position with the broker is closed, the broker’s offsetting position with the bank is simultaneously closed.
With this (NDD) model, there is no conflict of interest between customer and broker, because for the broker every downstream profit (from the customer) is offset by an upstream loss (to the bank), and vice versa.
When a retail customer opens a trade with a retail forex broker [I]— any type of broker —[/I] a two-party transaction is entered into in which the customer and the broker are counter-parties to each other. That relationship continues for the duration of the trade, regardless of what the broker might do to offset his side of the transaction.
For this reason, the CFTC (the U.S. regulator) refuses to refer to any forex broker as a “broker”. Instead, the CFTC insists that they are all “dealers”, because of this counter-party relationship. In fact, the CFTC invented a new designation for retail forex “brokers” — Retail Foreign Exchange Dealers (RFED’s).
I, for one, will continue to call them brokers.
Some NDD-brokers use loose terminology, implying that all of their customers’ trades are “handed off”, or “passed upstream” to the interbank. As the CFTC has made clear, this does not and cannot happen.
[I]The counter-party relationship between customer and broker cannot be transferred to a third party;[/I]
it can only be offset, to remove market (price) risk.
Well, I didn’t mean to write a book in response to your question, but it is what it is. I hope it’s helpful.
.
