Forex Broker Guide
The hub of world-wide Forex trading is the inter-bank market, in which large commercial banks buy and sell foreign currencies for their own accounts and on behalf of clients. Inter-bank trades feature the tightest bid-ask spreads--the difference between the highest bid price and the lowest ask price for a currency pair. All currencies are traded in pairs, representing a purchased currency versus a sold currency. Unless you are a large commercial bank, you require the services of a broker to trade in the inter-bank market, or you can bypass that market entirely and trade with a Forex market-maker.
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Market Makers
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A Forex market maker is a dealer that creates its own set of bid/ask spreads apart from those on the inter-bank market. The dealing desk at a market maker sets prices for customers, and stands ready to buy and sell foreign currencies from customers. Dealing desks may maintain their own foreign currency inventories or may pass on trades to other counterparties. If trades are kept in-house, a market maker is trading against the best interests of its customers because Forex trading is a zero-sum game and only one side can win.
Electronic Communications Network Brokers
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An ECN broker deals directly with the entire inter-bank market or with some cross-section of it. ECN brokers never act as trading counterparties to customers; they simply relay a customer's order, which is executed in the inter-bank market on the basis of the best available price. That is, the highest bid will be first in line for the next buy order, and the lowest ask will have rights to the next sell order. For its trouble, an ECN broker charges a trade commission and perhaps a small variable spread (as compared to the larger fixed spreads offered by market makers). ECN brokers are major market players, and seldom accept trades smaller than a standard lot ($100,000). Therefore, smaller speculators may not have access to ECN brokers.
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Contrasts
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In addition to the difference in roles as counterparties, ECN brokers and market-makers differ in several other ways. When volume is high for a given currency pair, an ECN broker may charge little or no spread, whereas market-maker spreads are fixed. ECN brokers offer open and transparent current bid/ask spreads for any currency pair; market-makers are free to set any prices they wish. ECN brokers have no financial incentive to manipulate prices, as they do not benefit from trade results. Market makers must continually resist the temptation to manipulate prices so as to cause a loss on the part of their customers and thus a gain for themselves.
Regulation
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In the United States, all retail Forex brokers and dealers must be registered by the National Futures Association and are subject its regulations and those of the U.S. Commodity Futures Trading Commission. Retail brokers must maintain a minimum capital reserve of $20 million and may not offer leverage exceeding 50:1. This means a broker may not extend more than $50 of margin credit for each $1 of funds provided by a customer. Internationally, high leverage ratios, up to 500:1, are obtainable. Leverage sharply increases the risks and rewards of Forex trading.
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