Market Makers Vs. Electronic Communications Networks
The foreign exchange market (forex or FX) is a decentralized global market in which exchanges do not take place on an exchange and do not have a physical address to do business. Unlike stocks, which are traded on stock exchanges around the world, such as the New York Stock Exchange or the London Stock Exchange, foreign exchange transactions take place over-the-counter (OTC) between agreeable buyers and sellers around the world. . This network of market participants is not centralized, therefore the exchange rate of any currency pair at any given time may vary from broker to broker.
The major players in the market are the largest banks in the world, and they form the exclusive club in which most trading activity takes place. This club is known as the interbank market. Retail traders cannot access the interbank market because they do not have credit relationships with these big players.Inasmuch asThis does not mean that retail traders are not allowed to trade currencies; they can do this primarily through two types of brokers: market makers and electronic communications networks (ECNs). In this article, we will cover the differences between these two brokers and provide an overview of how these differences can affect forex traders.
How Market Makers Work
Market makers “set” or fix both bid and ask prices on their systems and display them publicly on their quote screens. They are willing to transact at these prices with their customers, which range from banks to retail forex traders. By doing so, market makers provide some liquidity to the market. As counterparties to every forex trade in terms of price, market makers must take the opposite side of your trade. In other words, every time you sell, they have to buy from you, and vice versa.
The exchange rates that market makers set are based on their own interests. On paper, the way they generate profit for the company through their market making activities is with the spread that is charged to their clients. The spread is the difference between the bid price and the ask price, and is often set by each market maker. Usually the spreads are kept quite reasonable due to the stiff competition among many market makers. As counterparties, many of them will then try to hedge themselves or your order by passing it on to someone else. There are also times when market makers may decide to hold your order and trade against you.
There are two main types of market makers: retail and institutional. Institutional market makers can be banks or other large companies that typically offer a bid/ask quote to other banks, institutions, ECNs or even retail market makers. Retail market makers are generally companies that are dedicated to providing retail forex trading services to individual traders.
- The trading platform usually comes with free charting software and news feeds.
- Some of them have more user-friendly trading platforms.
- Currency price movements may be less volatile than currency prices quoted on ECNs, although this may be a disadvantage for scalpers.
- Market makers may have a clear conflict of interest in executing orders as they may be trading against you.
- They may show lower bid/ask prices than you might get from another market maker or ECN.
- It is possible for market makers to manipulate currency prices to execute their clients’ stops or not to let clients’ trades meet profit targets. Market makers can also move their currency quotes 10-15 pips away from other market rates.
- A huge amount of slippage can occur when news is released. Market makers’ quote display and order entry systems may also “freeze” during periods of high market volatility.
- Many market makers frown upon scalping practices and tend to put scalpers on “manual execution”, which means their orders may not be executed at the prices they want.
How ECNs Work
ECNs transmit prices from multiple market participants, such as banks and market makers, as well as other ECN-connected traders, and display the best bid/ask quotes on their trading platforms based on these. price. ECN-type brokers also serve as counterparties to FX transactions, but they operate on a settlement rather than pricing basis. Unlike fixed spreads, which are offered by some market makers, currency pair spreads vary on ECNs, depending on trading activity in the pair. During very busy trading periods, you may sometimes get no ECN spread, especially in highly liquid currency pairs such as the majors (EUR/USD, USD/JPY, GBP/USD and USD/CHF) and some currency crosses.
Electronic networks make money by charging customers a fixed commission for each transaction. Genuine ECNs do not play any role in manufacturing or pricing, therefore, risks of price manipulation are reduced for retail traders.
Just like with market makers, there are also two main types of ECNs: retail and institutional. Institutional ECNs relay the best bid/ask from many institutional market makers such as banks, to other banks and institutions such as hedge funds or large corporations. Retail ECNs, on the other hand, offer quotes from a few banks and other traders on the ECN to the retail trader.Inasmuch asInasmuch as
- You can usually get better bid/ask prices because they come from multiple sources.
- It is possible to trade on prices that have very little or no spread at times.
- Genuine ECN brokers will not trade against you, as they will forward your orders to a bank or other client on the opposite side of the trade.
- Prices may be more volatile which will be better for scalping purposes.
- Since you are able to bid a price between bid and ask, you can take on the role of market maker to other traders on the ECN.
- Many of them do not offer integrated charts and news feeds.
- Their trading platforms tend to be less user-friendly.
- It can be more difficult to calculate stop-loss and breakeven points in pips in advance, due to the varying spreads between bid and ask prices.
- Merchants have to pay commissions for each transaction.
The type of broker you use can have a significant impact on your trading performance. If a broker fails to execute your trades in a timely manner at the price you want, what could have been a good trading opportunity can quickly turn into an unexpected loss; therefore, it is important that you carefully weigh the pros and cons of each broker before deciding which one to trade.