Make sure you’re with the right broker. Know what you want, know what you need and find the broker that delivers on both. In this article, we’ll discuss the factors that’ll help you make the right choice.
What is a broker?
A financial broker conducts transactions between buyers and sellers of financial products. They earn a commission when the deal gets done. Some brokers will act as a buyer or seller and become a principal party. This basically means they take the other side of the trade. If you're buying, it's the broker that's selling.
What is a stockbroker?
A stockbroker is a regulated professional that (normally) represents a brokerage firm or broker-dealer. They buy and sell stocks (shares in a company) for both retail and institutional clients. Whilst their focus tends to be on stocks, they might also dabble in other securities like forex and commodities. Stock brokers will make trades on behalf of their clients through stock exchanges and get paid via fees and/ or commissions.
What is a broker-dealer?
A broker-dealer is another term for a financial broker. They work with individual investors or firms who want to buy and sell securities.
Broker-dealer’s act as both a broker and as a dealer.
When acting as a broker, they’re middlemen for transactions between two different investors exchanging securities.
When acting as dealers, they are buying or selling for their benefit and on their account.
What does a broker do?
Brokers are middlemen between you and the trading world. They match buyers with sellers. If you want to sell an asset at one price, they will find a buyer.
They now provide you with the trading platforms to take trades and give you the opportunity to be matched with either a buyer or seller (depending which one you are).
Due to the competitive nature of the forex broker industry, brokers are now doing more and more. They offer their clients education, tools, plus a host of services and products in an effort to appeal to their prospective clients.
What qualifications do brokers need?
As an individual broker within a brokerage, you don't need to have any type of qualification. Some brokerages might have stricter requirements than others but in general, there is no requirement like there is for accountants, doctors or architects.
To open an execution brokerage business, no-one in the business needs any specific qualifications. To be authorised by certain regulatory bodies you must adhere to their standards and protocols. Each authority is different and will have its own level of compliance. It, therefore, depends on the country in which they operate and where they're legally registered.
To be regulated by highly regarded authorities like the FCA you must comply with strict protocols. Whilst you don't need any qualifications to start a brokerage, the FCA will assess the experience, fitness, and propriety of senior management before agreeing to authorise them. It's not like anyone can just open a brokerage.
How do brokers make their money?
Brokers make their money by charging you to execute a trade, both sides, when you’re buying and selling. Normally the charge comes in two forms, a commission per transaction or a spread - the difference between the price they quote you to buy and the price they quote you to sell. The actual price of the asset will be somewhere in the middle.
The two prices you’re quoted are called the bid and the ask price. Here’s an example to show you how a broker makes money on a forex trade.
The market price is 1.5000.
The spread of the currency pair is 2.
You are trading at £10 a pip.
The bid price would be 1.4999.
The ask price would be 1.5001.
If you buy in this market, you will enter the market at 1.5001 whilst the actual price is still at 1.5000.
You enter at a loss because you are paying that 1 pip to the broker.
Therefore you will pay the broker £10 to enter the trade.
Broker profit = £10.
Spreads can be either fixed or variable. Variable spreads change depending on how the market moves. If there’s a significant economic event or data release such as an interest rate change, the spread could quickly change due to the volume of orders trying to get matched. Using the example above, if the spread widened to 3 during an announcement and you continued to buy, you would pay the broker £30 rather than £10.
Brokers can also charge commissions and a spread on a trade. This would mean you pay the spread as per the above example but you would also be charged a set fee per transaction. You’d be wise to stay away from these types of brokers as costs can spiral.
Brokers who are well-capitalised and work with tier 1 banks usually offer the most competitive pricing.
What are the different types of brokers ?
Several different types of brokers can execute your trades. There are:
No dealing desk brokers (NDD)
- Electronic communication network brokers (ECN)
- Straight-through processing brokers (STP)
Dealing desk brokers (DD)
No dealing desk brokers
No dealing desk brokers (NDD) are, unsurprisingly, those that don’t operate dealing desks. Your order gets sent directly to the market without any interference or delay.
NDD forex brokers will normally work directly with several liquidity providers to get you the most competitive prices.
With NDD brokers, you get direct exposure to the precise spreads available to customers from the interbank market. The precise spreads are normally passed on to the client but in order for them to make money they will apply exchange fees or commissions to your trades.
A straight-through processing broker (STP) will route your order to the market ASAP without any delay and interference. Like most brokers, they make money from the spread and the commissions they generate on the trades you place.
STP brokers pass the orders directly to their liquidity provider. Liquidity providers can include Banks, Hedge Funds, Investment corporations or other brokers. STP brokers usually have several liquidity providers; increasing the number of providers in the liquidity system should, in theory, lead to better fills for the client. Many STP brokers use banks who trade on the Interbank market as their liquidity sources. The Interbank market is the highest-level foreign exchange market where banks exchange currencies.
A few key facts about STP brokers:
They don’t pass orders through dealing desks
They process clients requests without delay
They don’t send re-quotes to clients
They allow clients to trade during volatile periods (like news releases)
An Electronic Communications Network (ECN) broker places your order into a liquidity pool of continually changing prices. The pool of pricing may be created by tier 1 banks who transact billions of FX requests and orders each day. ECN brokers attempt to get your market order filled at the best price and ASAP.
The ECN provides an electronic system for buyers and sellers to come together to execute trades. The network matches all the buying and selling orders in the pool of pricing (the exchange). If specific order information is not there, then the ECN delivers the highest bid and lowest ask price on the open market.
All ECN brokers have access to the same feed and trade at the prices quoted. They’re popular because no trader should have a built-in advantage over the other.
Hybrid Broker (ECN + STP)
Brokers who offer the dual system of STP and ECN are known as hybrid brokers. Orders are routed to the ECN liquidity pool and market ASAP, without any interference or price manipulation. These hybrids are considered one of the most efficient, transparent and safest methods for traders to access markets.
Dealing desk brokers
As the name suggests, a dealing desk broker operates a dealing desk. The issue many have with brokers working dealing desks is that they often take the other side of a clients trade, therefore are the counterparty. This then throws up the question, does the broker have the clients best interest at heart when they’re the counterparty?
By setting the bid and ask price, there’s an argument that they have an advantage over their counterparty, in this case the client. Some people do believe that this type of trader takes advantage of traders but there are also many others that appreciate the fixed spreads that they do offer.
A market maker makes a market for their clients. They’re often liquidity suppliers - an entity that buys a large volume of an asset and then distributes it to other financial institutions who then make it available to retail investors.
Market makers offer a buy and sell quote to other financial companies, and they make a profit from this bid-offer spread. Their mission is to provide competitive quotes for the complete trading ecosystem.
How do you choose a broker?
Choosing a broker is an important decision when you start trading. The charges they apply will have an affect on your bottom line.
As an example, imagine you're an FX trader taking around ten trades a day. You pay an extra pip or two per transaction (let’s stick at the low level and call it 1), and you’re looking to bank on an average of ten pips per trade.
That means you’re looking to make 100 pips in a day. If you’re paying 1 pip to get in and 1 pip to get out of the trade, it means you have to make 12 pips on each trade to hit your target. That means you have to make 20% more profit to hit your 100 pip target. Minimising your transaction costs is essential.
So how do you actually choose a broker? What’s the best process?
The same way as choosing any provider. Doing your research and creating a checklist of everything you want in a broker. This might include security, value or customer service, or ideally all of the above. We’ve put together a few suggestions of the types of things you should have on your checklist when you’re doing your research
Are they regulated? Who are they regulated by? It’s always sensible to go with a regulated broker so do make sure this question makes it onto your checklist.
What do the clients of the broker say about them? Bad news travels quickly on the internet, especially in the trading community. So if the broker has lots of genuinely poor reviews, you might want to cross them off your list.
Spreads and costs
How much is it going to cost you to trade with the broker? As we mentioned previously, this affects your bottom line, so make sure you’re on the hunt for value. As an example, anything over a 2.0 pip spread on EUR/USD is too much.
Will the broker offer you good support? Credible brokers will stress their customer support, sometimes, more than they’ll highlight their costs. They really want to deliver the best possible service to you because you’re more likely to stay with them. Loyalty repays loyalty.
What is their trade execution and management like? You won’t know this unless you test their demo or check whether they’ve won any awards. Either way, having a platform and all the order types you need is important, so do look out for any clues they might give you (namely awards).
Education and tools
Do they want to make you better? A broker who wants you to improve, wants you to win. That is something you’ll have in common with the broker … wanting to win. Check out their tools and education section to see what they have on offer, the more the better.
What is the legal status of the firm? Fairly self-explanatory. You want to go with a broker that’s a solvent Limited Company with a significant paid-up share capital to satisfy their regulators. Check their legal section for all the boring but important information.