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The foreign exchange market (forex or FX) is a global market in which trading occurs in a retail off-exchange environment, which means there isn't a localized exchange where everybody trades and it is primarily done through an online trading platform provided by different Broker firms.
Unlike equities, which trade through exchanges worldwide such as the NYSE or the NASDAQ, foreign exchange transactions take place over-the-counter (OTC) between buyers and sellers from all over the world. Because this network of participants is not centralized, the exchange rate of any currency pair can vary from one broker to another. (To get a complete overview of forex, see The Forex Market and Forex Basics)
The main players in the forex market are the top banks in the world. This group creates the market for currency trading and they are known as the interbank market. Retail traders are unable to access the interbank market, but they can trade forex through two types of brokers: market makers and electronic communications networks (ECNs). The main differences between these two types of brokers and how they can affect your forex trading, are discussed below.
Forex Market Maker Broker
Market makers "make" or set both the bid and the ask prices on their trading systems and display them to their customers, on their quote screens. They stand ready to make transactions at these prices with their customers, who range from banks to money managers to individual retail forex traders. In doing this, market makers provide some liquidity to the market. As counterparties to each forex transaction, market makers must take the opposite side of your trade. In other words, whenever you buy, they must sell to you and vice versa.
The exchange rates that market makers set are based on their internal guidelines. They mainly generate profits through the spread that is charged to their customers. The "spread" is the difference between the bid and the ask price and is often fixed by each market maker. Spreads typically remain competitive due to the number of market makers providing services in the retail off-exchange market. By generating profit on the spread, market makers can offer "no commission" or "zero commission" trades. Since these market makers are counter-parties to your transaction, they will often hedge the transaction, but may decide to hold your order and trade against you.
The two main market makers in the industry are Institutional market makers and retail market makers. Institutional market makers are banks or large corporations who usually that offer quotes to other banks, ECN's or corporations. Retail market makers are solely dedicated to offering retail off-exchange forex trading to individual traders.
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Forex ECN Broker (Electronic Communications Network)
An ECN collects prices from numerous market participants, ranging from banks to market makers to other ECN's and they display the best possible bid/ask quotes on their trading platforms based on the prices they receive. When ECN's act as a counterparty, it is on a settlement basis as opposed to a pricing basis. Depending on a currency pairs volatility, an ECN's spread may be more or less and is often not fixed.
ECN's generate profits by charging a commission for each transaction. Some of them do not make a profit on the bid/ask, but some of them do, in addition to the commission. You should take into account your overall trading strategy and how commissions on a trade may or may not affect you as a trader.
ECN's may also be Institutional or Retail. Institutional ECNs relay pricing from numerous banks to other banks and corporations. Retail ECN's usually relay pricing from just a few banks to individual retail off-exchange forex traders.
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Choosing the Right Forex Broker
Your trading performance can be impacted by the particular broker you choose. Are you going to adopt a long term trading strategy or a short term trading strategy (scalping)? Do you have nerves of steel or would you rather have an Expert Advisor (automated trading robots) do the trading for you? These are all questions you must ask yourself when choosing the right broker for you. For more information about choosing the right broker, please click on the link for "How to Choose the Right Forex Broker".
John A. Taxiarchos is a seasoned professional investor/trader with over 10 years of experience in the equities, futures and FOREX markets. John started his career as a registered representative for a Top Ten Investment Bank. As trading technology advanced, John shifted focus on trading strategies in the Forex market. He is currently a Market Analyst for Traders Choice FX: www.traderschoicefx.com
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