Know Your Broker!

Forex (Foreign Currency Exchange) traders invest a great deal of time worrying and discussing their various concerns regarding the retail brokers they use to handle their money. It's natural to presume that to make money in forex simply means to 'beat the market' by finding and making top quality trading opportunities. In truth, there is a lot more to it; the broker which is honoring your trade will greatly impact how successful you are.

Most people stay away from so-called Bucketshops; retail brokers which quote questionable prices, seem to manipulate prices for their own gain, and actually trade to the detriment of their clients. This practice (although many say they don't do such a thing) creates an ethical conundrum that naturally benefits them and against the traders. The term 'Market Makers' as well is often used to describe those companies that in fact take the opposite side of their own clients' positions. Because they present their own version of prices and fill the clients' trades directly from the company's own portfolio, they are truly creating the market. A hard look at the environment of currency, however, shows us that such a practice is in fact vital to making it possible for small retail trades to occur, and although it can be.

The reason this is true is because there is no actual 'Forex market', in the way that there is for other types of investment. As an example, company stocks are traded primarily through official stock exchanges -- the NASDAQ being among the most prestigious. All trades executed by way of an exchange such as the New York Stock Exchange is cleared through that exchange, traded according to the standards of that exchange and moved through brokers who are overseen by the exchange. Stock exchanges set the hours of business and have the ability to determine if any stock or brokerage needs to be expelled or suspended as the result of practices that run the risk of harming the overall market. These exchanges have known brick and mortar offices and are in turn regulated by government offices.

The Foreign Exchange market, by contrast, is constituted largely of huge institutions that need to exchange capital with other nations. They are important institutions; banks and giant conglomerates which have to transfer capital from a specific currency to a different one so that they are able to do business from one economy to a different one. If a Japanese company sells products to an American company, it will probably be paid in the form of $US, but it have to pay its internal bills in the form of Japanese Yen, therefore it must be able to convert massive amounts of currency on a consistent basis. This is the true Forex market; corporations and banking institutions that shift trillions of dollars worth of currency back and forth every day. Retail traders like us could never participate in that market -- we obviously don't have that much capital.

Because of this a Forex broker must have the ability to trade currency directly with their clients. The brokers create manageable trade opportunities for the under capitalized players (that's us) who might otherwise never be able to get into the Forex market. They, in turn, perform much bigger trades with their 'Liquidity Provider'; a financial institution able to trade with brokers for the purpose of making some profit from the retail traders. On our own we'd never be able to catch the attention of the big time banks. It simply would not be feasible for them.

Because of this, a trader must rely on his broker to offer their own currency prices rather than getting a guaranteed price from a central exchange. Each broker has to use prices provided to it by its bank(s) which are not assured to be the same as those published by other liquidity providers. Those disparities are seen in the disparity between broker quotes. It is not an attempt to screw the customers (although some unscrupulous brokers undoubtedly do) it's simply a necessity of making the market for you to participate in. A broker may be ethical and still have the need to trade opposite its customers, even though they're not trying to misquote prices and make those clients lose.

So you see, for most trades a retail brokerage will be forced to 'trade against' their customers, though they are constrained by legal and ethical conventions not to do so in a way that harms those clients. This makes for a serious situation of 'caveat emptor' - that is, let the buyer be careful. All speculators and those trying to learn forex must thoughtfully select their brokerage and should actively watch the trade and price activities to make sure that they are being handled equitably. It would be improper, after all, to infer that a broker who takes the other side of a client's trades is doing so to screw them. It may sound bizarre and also a little unsettling, but it's a necessary and crucial aspect of the retail foreign exchange business model.