Forex trading has come a long way for retail traders over the last few years. I remember starting out with CMC brokers a good fifteen years ago. They had a spread you could drive a truck through but they were one of the first outfits which catered for retail forex traders. These days there are no end of brokers offering some great services with really tight spreads. Beginner traders in forex may not be aware of this but there are in fact different types of forex accounts and one should think very carefully about which type you choose when starting out. Let me explain a bit.
Single-Counterparty or Market Maker Account
When you take a trade, there’s always someone taking the other side of it. With a single-counterparty broker it’s the broker who quotes you your two-way price and who takes the other side. The idea is of course that with enough two-way business going on they’ll be fairly well hedged and will be making the spread each time as their profit. All well and good but in practice it’s not as simple as this. The broker may well not have enough business to be properly hedged so then they need to decide what to do about it. Fortunately, they are party to a great deal of extra information to help them make their mind up. For one thing they can and do track each client to see if they know what they’re doing – they typically divide their clients into two camps, the A book and the B book. If they’re good traders then the broker may well just hedge their trade (or even duplicate it if they really trust the trader). If the client is no good then they’ll simply take the other side of the trade, the old “bucket shop” approach. For those who aren’t familiar, a bucket shop was an old stock broking firm which would take orders from clients but instead of actually executing them would throw the ticket in a bucket and just take the other side of the trade knowing that most of the traders were going to lose money so they would profit.
Now I’m sure that astute readers can see that there is a great conflict of interest here for the broker who is making the prices themselves and might also be on the other side of a clients trade. For starters, the broker knows exactly where your stop loss and take profit orders are. Obviously, the temptation to nudge the price to hit your stop loss or to hold back the market just before your take profit level would be considerable. What’s more there are a number of tools for Metatrader brokers which will allow them to nudge prices in precisely this way so don’t think that it never happens because it does. Now, I’m not saying that all firms do this – for larger firms who’ve been around for a while and who have a reputation to uphold they may well shy away from such behaviour but traders should very much be aware of this possibility. I would say that in general, the larger the time frame that is being traded, the less of an issue this becomes: no broker is going to nudge the price several hundred pips to knock out your stop so you should be fairly safe there but if you’re trying to scalp a few pips with a market-maker account then you should be very wary.
Futures traders might be surprised to learn that such things as Market Maker Accounts even exist. In their world there is a single exchange where all the trading takes place. There’s no question about the price or the quote and there’s no scope for skulduggery (except directly in the market itself!) and everything is above board. Fortunately such things exist in the forex world as well with ECN accounts whereby some liquidity providers (usual banks) provide constant two-way quotes on the “exchange”. I say “exchange” but it’s not like there’s only one, you still have the problem of there being no single forex market as such but at least all these liquidity providers are (presumably) quoting the same price across a large number of platforms so you’re basically getting the correct global price. As the broker is no longer getting the spread they are instead compensated by the trader paying a commission. In general, even after commission, ECN trading is tighter than most Market Maker Accounts. What’s more with ECN accounts there’s none of the shenanigans that might go on with the Market Maker Accounts. The conflict of interest with the broker is now removed and in fact they want you to succeed as then you will be around to pay them commission for longer. In fact the only downside to ECN accounts is that some brokers have a higher minimum account size than the Market Maker Accounts but these days it can be as small as $1k.
an ECN broker will have multiple liquidty providers
So there you have it. Two types of forex brokerage account but two very different beasts. Is there any reason for using a Market Maker Account then? Well, one reason might be if you want to trade big size and if you want to be sure of what your price is for that size. Your market maker broker might say that it’s quote is good for up to $10 million for example whereas on an ECN you’d be taking out several layers of the depth of market if it’s relatively small and you’d have to worry about hitting an “air pocket” if you take out all the bids or offers. This would therefore be a legitimate reason for using a Market Maker Account. This reason aside, personally I can’t otherwise understand why anyone would willingly trade with a Market Maker Account if they didn’t have to and I only use ECN type of accounts. In due course I’ll be posting various reviews of brokers which I’ve personally used.