Business Models of Currency Trading Brokers
Most online forex brokers function as the market-maker for your trading, meaning that the broker is on the other side of every trade — when you buy, you’re buying from the broker; when you sell, you’re selling to the broker. Brokerage firms that are market-makers typically provide both consistent liquidity and execution, which allows you to trade your desired amount at all times.
Market-makers typically offer either fixed spreads or variable spreads:
Fixed spreads remain constant all the time, regardless of what’s happening in the market. Because the broker must assume the additional market risk of quoting a fixed spread all day long (including in thinly traded or volatile markets, when interbank spreads tend to widen), fixed spreads tend to be slightly wider than variable spreads.
Variable spreads fluctuate depending on market interest. In highly liquid periods — such as the overlap between the London and New York sessions — variable spreads will be the tightest (as low as 1 or 2 pips in EUR/USD and the other heavily traded currency pairs). In slower periods (such as 6 p.m. Eastern time [ET], when New York is closed and Asia is not yet fully online), spreads will tend to be wider.
Whether you should choose fixed spreads or variable spreads largely depends on your trading style. If you’re a short-term trader looking to make just a few pips on each trade, you’re probably better off with variable spreads, which are tightest in liquid markets. If you trade around news, fixed spreads will allow you to avoid the inevitable widening of spreads (sometimes by a significant amount) that typically happens around fundamental announcements.
Another model being promoted by a few brokers is the nondealing desk model. The term is meant to differentiate these brokers from market-making brokers — who have trading, or dealing, desks — that manage the firm’s market exposure.
Nondealing desk brokers will tell you that the price you’re trading on is coming directly from the interbank market and that they route all your trades directly to the banks. But if that’s the case, why is the nondealing desk broker even needed?
Online forex brokers have emerged precisely because the large institutional players did not have the capacity to process tens of thousands of individual trades.
More important, if the nondealing desk is commission free and routing every trade to a bank, how does it make any money? A legitimate nondealing desk firm will offer very tight bid/offer spreads and charge commissions for each trade.
Commission-free forex brokers are compensated by the spread between the bid and the offer. If you buy from a broker at 15, for example, and another trader at the same time sells to the broker at 14, 13, or 12, the broker realizes a profit from the spread.
The reality with the nondealing-desk approach is that such trading platforms may display wider prices and sharper price gaps during periods of volatility, all the while claiming no control over the prices being shown. Be careful about promises of dealing in the interbank market — if it sounds too good to be true, it usually is.