When you choose to trade forex, you have to be aware of the high risk involved in navigating the forex broker scene. With 2020 retail investor losses differing by UK broker, you must be able to understand how forex brokers make money. A topic that we explore in the article below.
To answer the question of how do forex brokers make money, we have to understand the business models of forex brokers and what this means for each style of account. We go over the types of forex brokers and then the three key ways a forex broker makes their money. Quickly jump to each topic using the shortcuts below:
To choose the right forex broker for you, it’s imperative that you’re able to understand how forex brokers make money.
While most forex brokers have a few common charges that you’re going to need to become familiar with, we dive a little deeper to help you fully understand the relationship between forex trader and forex broker.
To become a consistently profitable forex trader, you’re going to have to understand where your money is going. We’re here to help you choose the best forex broker and trading account type, for your own trading style.
One of the most common questions we are asked by new traders is, should I trade with an ECN forex broker or a market maker?
Well, let’s start by going over the difference between the two broker business models and whether they implement a dealing desk that executes your trades or not.
The first business model we want to go over is the ECN forex broker.
ECN stands for Electronic Communications Network and is essentially a real-time connection between yourself and other participants within the forex market. These could be:
True ECN forex brokers offer traders direct access to the best bid and ask prices, with no interference from a middleman. This means that during times of peak trading volume, the best bid and ask prices being offered by multiple participants in the interbank market may be the same and therefore display a spread of zero!
To compensate for these extremely tight spreads, ECN forex brokers make money by adding a small commission charge to each trade.
While ECN accounts are favoured by styles such as high-volume traders who scalp or run automated systems that require razor-thin spreads, it’s worth keeping in mind that spreads are still at the mercy of the forex market. If there’s no price available due to volatility or market hours, then the spread will not be zero.
You can be assured, however, that there is zero conflict of interest between the trader and an ECN forex broker. Because they aren’t setting the prices and instead are taking a commission on each trade, they want you to make money. If you’re making money then you’re trading more volume and therefore paying more commissions.
A symbiotic relationship between the forex broker and trader!
The second business model in operation is the STP forex broker.
STP is short for Straight Through Processing and while also being a no-dealing-desk model, it differs slightly from the true ECN model explained above.
STP forex brokers route client orders through to liquidity providers who quote bid and ask prices.
With liquidity providers having a plethora of quotes, the STP forex broker will aggregate these to ensure you receive the best price possible, but with a spread-markup added.
For example:
EUR/USD bid/ask prices from a liquidity provider
EUR/USD bid/ask prices after STP forex broker markup
When trading forex on an STP account with your broker, you’ll see a spread of 3 pips rather than 1.
With an STP forex broker, you’re trading against other participants in the market, not the retail forex broker themselves. This is important because like the ECN model, this ensures that there is no conflict of interest. The broker wants you to succeed because they are making money on the spread markup added to every trade, not because they’re taking your losses.
Another example of a symbiotic relationship between the forex broker and trader.
The third and final business model is that of a market maker forex broker.
Market makers are forex brokers who operate a dealing desk to execute orders. They make a market for their clients, creating bid and ask prices for liquidity and matching buy orders with sell orders already on their book in order to minimise risk.
Or by simply becoming the counterparty to their clients’ positions, by taking the other side of the trade themselves.
Forex brokers who are market makers make money through spreads, as well as by betting against their clients’ positions. This conflict of interest is why many traders find it hard to trust market makers, even if these fears are often unfounded.
The one big positive of market makers is that they’re the only forex broker able to offer fixed spreads to traders.
It all depends on what you’re looking for in a forex broker.
View UK ECN Forex Brokers >>
Now we understand the different types of forex brokers, let’s move onto the different types of charges that forex brokers use to make money.
The first key charge that forex brokers use to make money, is through their spreads:
Bid price: The price quoted for selling a currency pair.
Ask price: The price quoted for buying a currency pair.
Spread: The difference between the bid and ask price, and the cut that the broker takes on your position.
If your trading platform displayed EUR/USD at 1.1000/1.1001, then the quote would indicate a spread of 1 pip.
Depending on the business model that your forex broker has implemented, spreads can be both fixed or variable. Both types of spreads have advantages and disadvantages, depending on the type of trader that you are.
We go over the two different types of spreads below.
If your forex broker offers fixed spreads, then you’re guaranteed that the price you see displayed on your trading platform, is the price you’re going to have your trade executed at.
Fixed spreads are often only offered by forex brokers that make their money as market makers.
If your forex broker offers variable spreads, then the spread you see will change depending on current market conditions.
At times of high market liquidity such as the London open, you may see extremely tight spreads, sometimes as low as zero. At times of major news releases, on the other hand, the spread can widen as market participants pull their orders.
Variable spreads are usually offered by ECN and STP forex brokers. As you can see, trading with each broker type can be both a blessing and a curse. While you may not see any price manipulation by your ECN broker, you’re completely at the whim of the market. Something that can be cut out if you choose to trade with a market maker.
The next key charge that forex brokers use to make money, is through commissions charged to traders when they open and close orders.
Commissions are most often charged by ECN forex brokers, to ensure they are still able to make money on trading accounts with spreads as low as zero. They aren’t running a charity after all!
Due to the intense competition between forex brokers, commissions these days tend to be quite low. Just check out Pepperstone’s commissions.
Pepperstone’s ECN Razor Account (per standard lot):
Using the Pepperstone example, this means that you’ll be charged $3.50 per leg. That’s $3.50 on the entry leg and then $3.50 more on the exit leg of your trade.
Each leg makes $7.00 total to open and close a one standard lot position in any currency pair. This is known as a round-turn and along with the razor-thin spread quoted, is your total charge for that trade.
Keep in mind that these commission charges are pro-rated according to your position size. As not everyone trades one standard lot per trade, you’ll be charged accordingly.
Compare Pepperstone v IC Markets commission charges by clicking that link and checking out the full comparison table of our two highest rated ECN forex brokers.
The final charges that you need to consider when answering the question of how do forex brokers make money are those placed under the ‘other’ category.
These other fees aren’t related to your trading, but rather all of the extras that are required for it to happen. They can differ greatly from broker to broker and most of them are completely optional extras for traders that are looking for that little extra edge.
Let’s take a look at some of the big ones here now.
Depending on how you choose to fund your account, you may be charged a fee.
The thing here is that a lot of the time, these fees come from the bank or payment provider and are not making the broker money.
Here are a few of the most popular deposit/withdrawal methods, and a look at some of the fees you may be charged:
Bank wire transfer: If you’re using a foreign bank to where your broker is situated, they may charge transfer or service fees. This is not your broker trying to make money, but just the cost of using the inefficient global banking system.
Credit/debit card: Credit card providers such as Mastercard or Visa may charge a transaction fee whenever you use funds on a card to fund your account. International currency fees may also apply if your account is not in the same denomination as your card.
Payment services (Skrill etc): Traders who don’t want to use their bank account or cards, often choose third party payment services such as Skrill or Neteller. While they facilitate the underbanked population, they’re also much more expensive than if you used either of the previous 2 methods.
Your account with a forex broker, can’t be used as a regular bank account to store your funds.
If you leave your trading account funded, but don’t trade for a certain period-of-time, then your broker will most likely charge an inactivity fee.
An inactivity fee is usually a monthly or quarterly charge that is applied to your account if there has been no trading activity for over 12 months. Again, the times and charges will vary from broker to broker.
How to avoid inactivity fees:
While inactivity fees aren’t exactly how forex brokers make their money, they’re worth keeping an eye on so you don’t get caught out.
Most forex brokers offer the MetaTrader 4, MetaTrader 5 and cTrader platforms free of charge to all clients. But some brokers also offer additional features and add-ons that you may not find on the standard version.
Additional trading platform extras may include:
You should also check out the broker we’ve reviewed as having the best forex trading platform – Axitrader. Axitrader has a ton of free add-ons for MT4 with a package they’ve called MT4 NextGen.
Features of Axitrader’s free MT4 NexGen:
Some of the larger forex brokers hire teams of foreign exchange market analysts and educators to help give their clients an edge.
Check out of some of the premium, subscription-based features below.
Professional market research: Market research and analysis from some of the best economic minds in the business.
Trader education: Alongside each forex broker’s public offering, there are often private educational classes and webinars available for an extra fee.
Trading signals: If you’re not interested in learning to trade forex, then subscribing to trading signals from a broker or partner, maybe what you’re looking for.
A lot of forex brokers offer premium, subscription-based features free for clients. You can also access a lot of interesting analyses and educational content with just a demo account too.
Always do your research between forex brokers, before spending additional money on premium features or services.
Now we understand how forex brokers make money a little better, we’re going to finish up with some final points that feature statistics of account losses per broker and then a frequently-asked-questions.
Now that we’ve answered the question how do forex brokers make money and what each business model means, lets shift gears a little bit to regulation.
Whether you choose to trade with an ECN forex broker or a market maker, you should always make sure that they’re regulated. Regulation should be a highly important factor when choosing a forex broker as you never know when you’re going to need guidance in the future.
Here are some forex broker regulatory factors to consider:
Safety of your funds: Regulated forex brokers will not mix clients’ funds with business operational funds. This ensures that in the case of the broker going belly-up, your funds will always be safe.
An avenue of recourse in case of any disputes: If you’re not happy with your broker’s response about a trading issue and would like to escalate the issue, then having a regulatory body to turn to is key. You just never know when you’ll need assistance in the future.
Transparency of operations: Regulated forex brokers must be fully transparent to regulators about both the trading and business side of the brokerage. Regulation ensures transparency.
Stop hunting is where price action moves in a way to trigger clusters of stop orders above or below key support/resistance levels.
Its human nature for traders to place stop orders in groups above or below these technical levels and stop hunting is the practice of the market (or broker), ensuring price triggers these orders.
Stop hunting is a natural market phenomenon that ensures big volume orders can be filled. The broker is not after your stop loss.
If market maker forex brokers are unable to match opposite orders on their book, they will often take the other side of the trade themselves. This means that they will make money if you lose.
ECN forex brokers, on the other hand, offer traders direct access to the best bid and ask prices. They make money on charging commissions so would rather you make money and keep trading high volume.
Forex brokers are not traders themselves. Even if a market maker is taking the opposite side of your position, it’s not because they’ve done their fundamental analysis and disagree with your rationale. It’s purely for risk management of their overall book.
Forex brokers are risk managers first and foremost. They focus on the order flow coming in and making sure that the entire book is never in danger of hurting the broker’s business.
When it comes to making a final decision on whether you should trade with an ECN forex broker or market maker, there is no correct answer.
There is no such thing as the right broker. No one type of broker is better than another, simply because of how they make their money. Each business model has its pros and cons that will appeal to different types of individual traders.
Would you rather trade on spreads as low as zero with commissions, or would it work out better for your trading if you just paid a commission-free spread markup?
Maybe for your trading strategy, you require fixed spreads that only a market maker can offer?
These are questions that only you as an individual can answer!
In conclusion, it’s worth ending this article by saying that contrary to popular belief, no forex broker is your enemy.
Go with whatever works for you and your trading style.
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