For what it’s worth i’ll drop this blog entry here - hopefully useful for the new traders who wonder what really is going on… it’s no conspiracy…we don’t buy or sell anything!!
How Retail Brokers Operate – well most…
Before we get into the depth of this question it’s important to realise that Retail Brokers are split into two categories, this clear split is rarely discussed, but essential in understanding how Retail Brokers operate.
The first category of Retail Brokers are used by many new and moderately experienced Retail traders. These are Market Makers (MM) and provide liquidity to the Retail clients. The immediate distinction of these types of Retail Brokers is that they aggregate all client orders, known as internal pooling and do not offer Direct Market Access (DMA) to all individual clients. These pooled orders are offset with each other by the Broker back of house, any remaining long or short exposure is then passed to the underlying Spot FX market according to the Retail Brokers risk appetite through its own Liquidity Providers (LPs) . A Retail Broker in this category will not pass all individual client orders to the FX Spot market – this is important to realise. It’s equally important to realise that this should not be frowned upon, this is a normal business model and without MMs the Retail FX community would not exist as we know it today – at least in the sense that we can open accounts with ridiculously small deposits of less than £100,000.
From personal experience, I would not hesitate to say that 98% of all Retail Brokers fall into this category, the remaining 2% of Retail Brokers fall into the secondary category of DMA. Gaining DMA is not cheap, it’s also not for new or moderately experienced traders either. As a rule of thumb, the typical minimum opening balance for a DMA Broker is around £100,000 for UK clients (likely to increase with new regulation coming into play in 2018) – ranging to $1M for US clients [the differences are due to geographical changes in regulation]. In fact, for US clients these accounts also require a minimum value of liquid cash and assets before an application can be processed depending on the account type being applied for.
So, what does this mean – it means that we are all [probably] using a MM Retail Broker. For the sake of completeness there are some MM Retail Brokers who distinguish who their profitable Retail clients are and choose to pass these orders to the underlying Spot FX market (depending on the size of the order and the track record of the Retail client – we can come onto this in another post: it’s known as A-Book and B-Book clients).
So, assuming we are all using MMs - are we then really buying or selling into the FX Spot Markets, or are we betting against the Retail Broker and their own individual clients (from an aggregated view)? This is the important question that you need to think about. With DMA, a transaction IS taking place, you are buying or selling a currency pair on the REAL UNDERLYING Spot FX Markets: however, this does not take place with typical MM Retail Brokers. You may find it entertaining to log into your trading platform, regardless of it being MT4, MT5, cTrader and any other platform – we all see the same two big buttons which say ‘BUY’ and ‘SELL’ – this is deeply misleading and incorrect terminology.
Personally, I would look at these as a ‘LONG BET’ and a ‘SHORT BET’. This is all you are doing as a Retail client, placing a bet with your Retail Broker. You have absolutely no interaction with the Spot FX Markets, you are also never buying the base currency and simultaneously selling the quote currency of the pair in question. So, you may be wondering why Retail Brokers run this business model, it’s quite simple really – it’s all about maximising the profit for the Retail Broker, and in some instances minimising the risk of real market exposure.
We all know that a currency pair has two price quotes and the difference is equal to the spread. This is the cost of the transaction that we Retail traders must pay, we are quite literally at the end of the chain in this ‘mark-up’ process – this spread is also the profit that the Retail Broker obtains. However, if the Retail Broker does pass our trades to the Spot FX Market, they themselves would also have to pay spread to the LPs. Therefore, a proportion of the profit made by the Retail Broker by spread is paid to the LPs, also in the form of spread.
The spread charged by the LPs is always less than the spread charged by the Retail Broker to the Retail client [you and me]. The net difference between the two is the Retail Brokers true profit. However, if the Retail Broker does not pass orders to the Spot FX market and rather offsets these orders back of house against the client pool, the Retail Broker does not have to reduce its profits gained from the spread we paid as Retail traders… read this a few times and the penny will drop.
Therefore, as Retail clients we are always interested in the lowest spread possible – this means Retail Brokers have high competition against one another to win business in the Retail sector. This creates a problem though, by reducing spreads the Retail Brokers profits are also reduced. How does the Retail Broker manage this? They don’t interact with LPs wherever possible and so manage to keep all the profit gained from spread. It’s all about profit maximisation for the Retail Broker, and therefore they don’t offer DMA. DMA reduces their profits – this is all in the small print when you open a live account, take a look.
So next time someone asks you “what do you do”; you’re most definitely not a trader but rather a speculator. Speculating as a Retail FX client is a highly misunderstood profession, at least from a knowledgeable point of view and understanding how Brokers operate.