If you’re new to Forex, the term ‘Forex broker’ might be new to you. So what is a Forex broker – and why do they matter to traders?
Well, Forex brokers are incredibly important. Broadly speaking, a broker is something that gives you to access financial markets to trade financial instruments.
Financial instruments include currencies, stocks, precious metals and CFDs. With this in mind, a Forex broker allows you trade currency pairs.
Brokers are middlemen
To help you better understand Forex brokers, let’s make a useful comparison.
When people look to buy property, they typically use an estate agent (realtor in US). These people use their contacts in the property market to help buyers and sellers come together. Essentially, estate agents are acting as middlemen.
A Forex broker performs the exact same function – except the market they specialise in is currencies. So if you want to trade particular currency pairs – you need to find a broker that provides access to your desired instruments.
Buyers & sellers
In the case of properties, the seller is the owner of that property. In the case of currencies, the seller is one of the world’s top investment banks. This includes the likes of Deutsche Bank, Credit Suisse or Barclays.
These are the banks that provide the currencies for traders to buy or sell. Because of their size, they do not deal with individual traders.
Therefore, a broker becomes necessary so that they can bridge the gap between big banks selling currencies and individual traders looking to profit from that activity.
The way this is achieved is simple. The broker gathers a pool of individual traders together. This pool is then collectively big enough to work with the banks.
As a result, many traders can begin trading currencies with very small amounts of money. This is why the Forex market is incredibly liquid.
How brokers make money
You might be wondering how Forex brokers make their money. Well, it’s through a commission based system. For being the middleman, the broker pays the banks a commission based upon the volume of traded currencies. Brokers make their profits by passing these commissions onto the traders (plus a little extra).
Some brokers advertise ‘zero commissions’ which can seem very appealing. This does not mean that they are not charging you for your trading activity. Instead, it simply means that they are charging the same fees in a different manner. When a broker offers this option they will usually be applying their charges within the difference you pay when buying and then selling a currency pair. This small price difference is called ‘the spread’.
This is known as ‘STP’ brokering or ‘straight through processing’. Keep in mind, the brokers are simply acting as the conduit between smaller traders and large banks.
Different profit models
Over time, brokers started to notice that most small traders (retail traders) lost money. Most had little experience and started speculating way before they really knew what they were doing.
So most retail brokers stopped trading very quickly. Clearly, this also meant that broker profits dried up to. Remember, a broker can’t make commissions if nobody is trading.
To solve this problem, some brokers implemented something called B-booking. It’s also known as ‘market making’. This involved brokers taking a position on the other side of their client’s trade, instead of passing it through to the banks. In other words, the broker would make a profit every time one of their traders placed a losing trade.
However, this model also has complications. It’s not in the interest of the broker for their traders to be profitable – which is an obvious conflict of interest. Many traders wish to operate with a broker that is on their side, encouraging them to actually make a profit.
There’s another problem too. The ‘market making’ model is not always clear to prospective retail traders. In my view, it’s why Forex traders must be familiar with how brokers work.
What to look for in a broker
As a trader, it’s very important to find a broker that offers good pricing and good trading conditions. Responsive and helpful customer support is also essential.
You should also understand exactly how your broker operates and whether or not they hold a market making license, or a standard STP license.
You can check this via the relevant regulator website. For example, UK based Forex brokers will be FCA regulated. The FCA website will show you what license they hold.
Keep in mind, a market making license is much more expensive than an STP license. If a broker has a market making license, it’s highly likely they will be using it.
Trading platforms & education
A good broker will also provide tools and resources that help you make money from your trading. For example, they will give you access to a trading platform. This should allow you to quickly find the currency pairs you want to trade, before allowing you to easily execute your orders. The platform should also help you track your trades, along with your profit and loss performance.
Many brokers also provide education and training to help you reach profitability. It’s in the broker’s interest to retain profitable traders, as they will make more commissions.
Common tools include charts that allow you to see the price movements of each currency. This helps traders conduct technical analysis. To assist with fundamental analysis, brokers will also provide news feeds and analyst research.
What is a Forex broker?
In conclusion, a Forex broker is a middleman that is vital if you want to trade currencies. But the way they operate is also important. In fact, it can affect your chances of success.
Remember, it’s much better to work with a broker that wants you to be profitable. Avoid brokers that have a market making license.
Ideally, find a Forex broker that operates on a purely STP basis and has educational resources to encourage consistent profitability.