Forex Brokers, Bucket Shops and Market Makers – Is There a Difference?

B Keith Dalton asked:

Forex (Foreign Currency Exchange) traders spend a lot of time worrying and discussing their various concerns about the retail brokers they use to execute their trades. The outward assumption is that when you attempt to trade successfully you are plying your skills against ‘the market’ and that’s the only adversary you must be concerned about. In fact, there is much more to it; the company that is executing your trade can greatly affect how successful you are.

Many traders avoid so-called Bucket shops; retail brokers that quote questionable prices, seem to manipulate them for their own gain, and actively trade against their own clients. This practice (although most try to deny it) creates a conflict of interest that of course works in their favor and against the traders. The term ‘Market Makers’ is also often used to describe these brokers who actually take the opposite side of their clients’ trades. They are making the market their clients are trading in, instead of passing those trades on to the broader market. A realistic examination of the Forex world, however, shows that this practice is actually essential to allowing small retail trading to occur, and although it can be abused, it is not necessarily a nefarious business model.

To understand why this is, you must first understand that the ‘Forex market’ is unlike other investment markets in that it doesn’t actually exist in a real-world sense. Company stocks, for instance, are traded on a stock exchange such as the NYSE or the NASDAQ in the USA. These exchanges are governing bodies that qualify each company to be traded, defines the terms of the stock trading contracts, regulates brokers, and ultimately clears each trade financially. They exist at a specific location, trade specific hours and have the authority to shut down trading of any stock or the activities of any broker they feel is acting illegally or in a way that impedes fair and honest trade.

By contrast, the Forex market is simply the combined trading of those who wish to transfer money from one currency to another. The actual ‘real Forex market’ consists of large multi-national corporations and international banks that transfer money around in order to facilitate world trade. If a Japanese company sell products to America, it will be paid in US Dollars, but it must pay its own bill in Yen, so it needs to be able to convert large amounts of currency on a regular basis. Companies such as this and the banks they use to transfer the currency are the actual market, and retail traders are incapable of trading in this sphere; they simply don’t have the huge sums of money that are of interest to the real currency players.

For this reason a Forex broker needs to be able to buy and sell currency directly with their clients. They provide small trading opportunities for the little guys (like us) who would otherwise never be able to participate in the Forex market. They, in turn, perform much larger trades with a ‘Liquidity Provider’ which is a bank willing to transact with brokers for the purpose of making some money from the retail traders. The banks are willing to buy and sell with a broker who represents thousands of retail traders whereas they would never consider trading with each and every individual. It simply would not be feasible for them.

So, a retail broker must provide price quotes to its clients, but there is no central exchange which guarantees the prices at any given time. A broker must use prices fed to it by its liquidity provider(s) which may not be the same as the prices quoted by other liquidity providers. This is why two different brokers almost never quote the exact same prices. It’s not an attempt to screw the clients (although some unscrupulous brokers undoubtedly do) it’s merely a necessity of making the market for you to participate in. A reputable retail broker will not attempt to make money from its clients by manipulating prices, but it must nonetheless take the other side of its clients’ trades in order to fill them.

So, in summary, we see that retail brokers are required to take the opposite side of all but the largest of their clients’ trades, but they should not use this to actively trade against them. This creates a serious situation of ‘caveat emptor’ — let the buyer beware. Each trader must carefully choose their broker and should actively monitor the trade and price activities to ensure that they are being treated fairly. It would be unfair, however, to assume that any broker who takes the other side of a client’s trades is doing so to screw them. It is a necessary, if uncomfortable part of the retail Forex business model.

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