Two Ways of Looking at your Broker
Forex (Foreign Currency Exchange) traders spend a great deal of time wringing their hands and discussing their various concerns regarding the retail brokers they engage to execute their trades. The outward assumption is that whenever you try to make money trading you are plying your ability against 'the market' and that's the only enemy you must be thinking about. In fact, there's so much more involved; the broker who is placing your trades can greatly affect how successful you are.
Many traders stay away from what are often referred to as Bucketshops; companies that quote inaccurate prices, apparently play fast and loose with prices for their own benefit, and actively trade to the detriment of their own clients. This kind of practice (although many insist they never do such a thing) amounts to a conflict of interest that definitely helps them and against their clients. Another phrase used for such brokers is 'Market Makers'. Due to the fact that they present their own version of prices and fill the customers' trades directly from the company's own portfolio, they are truly creating the market. A truthful examination of the currency market, however, reveals that such a policy is truly vital to allowing small retail trading to happen, and although it can be.
The reason for this is because there's no actual 'Forex market', like there is with typical varieties of investment. As an example, company stocks are available primarily by way of typical stock exchanges -- the AMEX being one of the largest. These exchanges are governing bodies who qualify every business to be listed, lay out the terms of the stock trading contracts, monitor brokers, and eventually clear all trades financially. Stock exchanges establish the hours of trading and can determine whether any stock or brokerage should be expelled or suspended because of practices that might compromise the market in general. These exchanges exist at real physical locations and are themselves monitored by governmental offices.
By contrast, the Foreign Exchange market is just the aggregate trading of corporations that need to exchange funds from a specific currency to a different one. Those involved are powerful institutions; banks and large companies which need to change money from one currency to a different one so that they will be able to buy and sell from one country to another. Imagine a corporation from Australia markets some goods to Canada. The payment will come in the form of Canadian Dollars, but the business will have to pay for its costs in Australian Dollars. It will need a convenient means of converting its currencies nearly every normal business day. This is the true Forex market; corporations and banks that move trillions of dollars worth of currency back and forth every day. Small potatoes traders like us could never participate in that arena -- we simply don't have that kind of capital.
Because of this a Forex broker must be free to trade currency directly with their clients. They create small trade opportunities for the under capitalized guys (like us) who might otherwise never be able to participate in the Foreign Exchange market. They, in turn, perform much larger trades with a 'Liquidity Provider' which is a bank that is willing to trade with brokers in order to make some profit from we retail traders. The large banks are capable of trading with an agent that represents many smaller traders despite the fact that they would never think of trading with every individual. When a broker bundles many trades into a larger transaction, it's a different story.
And so, retail brokers needs to publish price quotes to clients, but there is not any central exchange which assures the prices at any given time. Every broker makes transactions with their own liquidity providers and different brokers can be expected to utilize different banks. That's why two separate brokers rarely have the exact same prices. It's not an attempt to screw the clients (although there likely will be those that do) but merely a necessary part of making the market for us to participate in. A broker might be upright yet still have the need to trade against its customers, even though they're not trying to misquote price quotes and cause those clients to lose.
So we can see, for the majority of trades a typical brokerage will be forced to 'trade against' their clients, although they are bound by legal and ethical conventions not to do so in a way that harms those clients. This creates a critical condition of 'caveat emptor' - that is, let the client beware. It is important to always keep a careful eye on the quoted prices and trade executions of their brokerage, and to pick that broker sensibly. To be reasonable, though, every speculator needs to recognize that their brokerage is forced to take the other side of their trades and they shouldn't suppose a treacherous motive. It's a fundamental, though disagreeable aspect of the small capital Forex business model.
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Tantalus - About Author:B. Keith Dalton has been studying and trading Forex for years, using his knowledge and experience in the realms of science, engineering, computer programming and statistical data analysis to help him understand the often confusing and chaotic world of Foreign Currency trading. He has made it a personal goal to help fellow traders by sharing his insights and understanding to de-mystify the Forex market experience.
You can read his blog here: Money Pipeline. He writes and sell Forex indicators and trading systems at Tantalus Online.
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