Comparing ECNs with Market Makers

[RichardCox 10]

One of the central differences between equities markets (which trade on exchanges such as the NYSE) and the foreign exchange market is the fact that forex is an unregulated market that is truly global in nature. That is to say, there is no single exchange or central address where the business of currency trading takes place. Instead of using entities like the London or New York Stock Exchange, currency traders enact transactions using over-the-counter (OTC) entities where buyers and sellers from all areas of the world meet to make their transactions.

 

Since these markets lack centralization, it is possible for the prices in a currency pair to see some slight variations between brokers. Most trading activities can be traced back to some of the larger banks in the world, and this is generally referred to as the Interbank Market. Access to this market is limited, however, and retail markets must use intermediaries in order to place transactions here (because retail traders lack the necessary credit connections).

 

Of course, this does not suggest that retail traders are totally excluded from placing forex transactions but in order to make these transactions, a broker must be used. There are two main types of forex brokers that aid in this process - Electronic Communications Networks (ECNs) and Market Makers. Here, we will look at some of the benefits and drawbacks of each type of broker as a way of understanding the ways each can affect the everyday practices of forex traders.

 

The Common Workings of Market Makers

 

Market makers get their name from the fact that they set, or "make," the Bid and Ask prices that are available to their retail clients in trading platform quote screens. The “clients” in these cases can include banking institutions in addition to smaller retail investors and part of the service Market Makers provide is to bring extra liquidity to the forex market.

 

To enable these trades, Market Makers act as a counterparty to every transaction, effectively taking the opposing side of each trade that is initiated by a client. In essence, when a client buys a currency pair, the Market Maker will enter into a sell position. If a sell trade is placed, the Market Maker must buy that currency pair from trading client. Given these factors, it can be concluded that the exchange rates set by Market Makers are at least in some way influenced by their own best interests. Market Maker profits are generated largely from spread charges (the difference between the Bid and Ask prices available to clients), which are typically fixed by the Market Maker.

 

Since Market Makers find themselves in a position to act as counterparties to client trades, there are many cases where they will hedge (cover) the orders by passing them along to a third party. In other cases, these companies will actually hold the orders and trade against the client.

 

Market Makers can be divided into two categories - Retail and Institutional. Institutional market makers tend to be banks or other types of large financial corporations which might offer a bid/ask quote to other banks or financial institutions, ECNs or possibly Market Makers in the Retail space. Retail Market Makers tend to be companies focused on offering forex trading access to individual traders.

 

Benefits of Trading with Market Makers

 

When looking at the trading platforms offered by Market Makers, most of the typical chart and news feed offerings can be found, but, in some cases, the platforms can be more user friendly, given the type of client that is targeted by these companies. Additionally, price movements in currency pairs might be less volatile (relative to the movements seen with ECNs). This will be viewed as a positive by some traders, although it will be a negative factor to others (such as scalpers or news traders) who need greater volatility in order to reach profits.

 

Drawbacks of Trading with Market Makers

 

One of the most common criticisms of Market Makers comes from the possible conflict of interest that can be present when orders are executed. This comes from the fact that Market Makers are put in the position to trade against client orders on a regular basis. With this, there is the added possibility that a Market Maker will display an inaccurate (worse) bid and ask price when compared to other brokerage companies. This comes from the fact that Market Maker’s are able to manipulate their price displays, run client stop losses, and prevent client trades from reaching profit targets. There is also a greater chance of slippage in prices when major news events are released.

 

While this is not to say that all (or even a majority) of Market Makers engage in these practices, it should be acknowledged that these possibilities exist. There are many examples of Market Makers which view scalping strategies as unfavorable and, as a result, some of these companies have placed scalpers on manual execution, which reduces the probability that these traders will be able to enter into the market at their preferred prices. In other cases, there have been cited examples of quote displays from Market makers which have frozen (stalled) during times of enhanced volatility in the markets.

 

In the next section of this article, we will compare these factors with what is typically seen with ECNs in order to give traders a better sense of how their trades are actually placed when new positions are opened.

[4EverMaAT 10]

when you read your contract carefully, you'll see that all retail brokers and are market makers. This isnt a bad thing....somebody's gotta be the counterparty to your trade to deal with it properly. as long as you get filled reasonably....who really cares.

 

the stigma that comes with MM term is a few less than scrupulous brokers did stop hunting, fake spikes, intentional price freezing, asyncronous slippage (positive slippage, no positive gain, negative slippage, trader gets full negative slip). This was further placed in the spotlight when the infamous virtual dealer plug-in got into the public view. metaquotes and related companies went through great lengths to suppress video and other proof of how it works. real eye-opener to see how easy it is to manipulate price feed vs orders. it is rare that a broker today will use the dealer (blatantly) as the competition is much better now and there are several reputable choices.