Inside forex – broker incentives

5 March 2015
The Market Owl

DMA, STP, NDD – if you trade forex, you know the broker choice alphabet soup.

Our take? Don’t miss the wood for trees: ignore acronyms and focus on incentives instead.

(If you’re feeling like a more in depth session on this, our FXStreet Brokernomics webinar that’s gotten quite a few hits).

Broker incentives

You go long 0.01 lots on the EUR/USD on your MT4, your broker sources them for you.

(This is less trivial than it looks – please bear with us for 3 lines.)

His incentives are aligned with yours: if the 0.01 lots don’t come at the then best possible price, you walk.

End of story? Not so fast!

Retail forex broker. Really?

10 years ago, if “forex brokers” had actually been brokers, forex trading in retail amounts wouldn’t have exploded:

  1. Currencies are traded over the counter (OTC): there isn’t a “market” where currencies are traded
  2. You couldn’t tap  inter-bank spot foreign exchange conditions for 0.1 EUR/USD lots

How is it that traders have traded forex in retail amounts for a decade already?

Breaking news! 95%+ of today’s ¨retail forex brokers¨ are actually broker-dealers.

To understand what makes them tick, think of Dr. Jekyll / Mr. Hyde.

download

Dealer incentives

Here’s how Dr. Jekyll & Mr. Hyde cooperate at retail forex broker-dealers:

Dr. Jekyll is your agent (broker). He sources  liquidity at the moment of your choice, at the then going market price, at arm’s length from “the market”, for your personal ticket size.

Ok, but what if the price for liquidity for your trade volume, at the moment of your choice, at arm’s length from the market isn’t very attractive? (your trade size is smallish and there’s a high volatility news release coming)

Introducing Mr. Hyde! As your dealer he provides last resort liquidity to “make your market”, taking the opposite side of your trade.

At night, Mr. Hyde’s also doubles up as a principal with shareholders. Unfortunately, in that capacity it so happens that your liquidity is “made” at a cost to his shareholder’s capital:

  • To finance the cost of the asset bought from you until it’s passed on to a willing buyer,
  • To face the risk that prices move against him in the meantime.

What’s in it for his shareholders? The b/a spread: Mr. Hyde buys off your asset, sells it to his “market” (customers like you), for a profit. The wider the spread, the lower the chance that adverse price movements hit, and the bigger his return. All of which makes Mr. Hyde’s incentives the exact opposite of yours.

As you let him deal your liquidity, answer:

  1. Do I  need last resort liquidity? (trade very small ticket sizes? trade the news? trade exotic assets?)
  2. If yes, do I always need it? (you could trade with a broker and, and only use the dealer when there’s no alternative liquidity)

Answered no at least once? All other things equal liquidity-wise, think twice before trading against dealers: their profit is their users loss.

Don’t see downside to dealing with Mr. Hyde? Heard of loss aversion, or asymmetric information?

Hint: do you make money systematically? If so intellectual property theft/leak should be TOP of your agenda…