What’s Wrong with Brokers Making Money?
Let’s start this post by addressing the elephant in the room. There is nothing wrong with forex brokers making money. And there is nothing wrong with how they do it, as long as they are not scamming you. It’s just hard to grasp what they do and how to value it. It goes without saying, just like every other business on earth, one of the top priorities is to make money, be successful, grow and survive. It’s not evil, that’s just life. Forex brokers are no different. While a simple analogy could be made with a retail shop such as a department store, it’s not quite so black and white. Brokers provide an intangible service, you can’t see it, smell it or touch it. When you buy something from a shop, you know if it was worth it or not. In most cases, trading with a broker is only worth it or not if you make money. Everything else, such as quality of customer support, trade execution and tools at your disposal are all hard to quantify.
Understanding how brokers make money is not as simple as a retailer such as Asos or Amazon, but it’s a good basis for an analogy. Retailers sell goods and the concept is binary. You either receive the products or not, it either works or it does not, it’s a better price than offered by a competing retailer, or not. This is where it gets even more complicated. If you make money from your trading you don’t really care how much your fees are to a certain extent. But if you lose your investment it’s easy to feel like you never received anything.
Let’s look at it a slightly different way. A forex broker and a retailer more or less do the same thing, they are the middlemen between someone selling a product and someone buying a product. Therefore, their business model is based on the same principles as retailers. They make money by adding an additional cost to the product sold as compensation for their services and cost of business. This cost is expressed in the form of markups and/or commissions. If you lose the capital which you invest, it’s similar to losing or breaking the product supplied by the retailer. It’s not their fault that this happened to you.
How Forex Broker Fees are Applied
Brokers can apply their fees in a number of different ways. It all depends on their business model and what type of traders they want to attract. Different trading strategies will prefer fee types. Broker fees can come in a number of different formats. Such as markups, commissions, swaps, rebates and market making and principal trading.
Liquidity and Markup
Just like in every industry there is a food chain. Banks are the sharks at the top of the forex food chain. Forex brokers get liquidity from a liquidity provider. Liquidity providers are institutional brokers known as prime brokers or prime of prime brokers. Banks sell to prime brokers, who sell to prime of prime brokers, who sell to retail brokers. The closer you are to a bank, the higher the financial requirement to get liquidity is. As well as the clear foodchain there is also a lot of cross-selling in this space. Prime brokers may work with other prime brokers to ensure they can always meet their client’s requirements, even if it means giving business to a competitor. Importantly all tiers of the supply chain will need to add a markup on the price in order to cover their distribution costs and make some profit too.
Therefore the entire business model is based on marking up. If your broker is receiving quotes for EUR/GBP at 0.89515 / 0.85920 from their liquidity provider, they may add a mark up on the price by making them slightly worse for the trader. In the platform, they may quote you 0.89514 / 0.85921. This means they have marked up by two points and the spread you get is 0.7 Pips while your broker is getting a spread of 0.5 from their liquidity provider.
One way for brokers to either reduce the spread or increase the amount they can make without overcharging is to aggregate prices from multiple liquidity providers. This is common practice as it allows brokers to essentially shop around.
Some forex brokers will charge commissions for every trade you make. This is separate to markup as it’s clearly identified in your trading account how much you have paid. A lot of traders prefer this to markups as they know how much they are paying and can factor it into their trading strategy. Markups, on the other hand, are variable and not very transparent. Commisions are normally charged according to the size of your trade. The way it’s expressed can vary between brokers, as it can be charged per Lot, per million USD or as a percentage of the trading volume.
Very similar to the concept of Markups, Swaps are charged or paid to brokers and those charges or payments are also paid to traders, plus or minus what the broker would like to charge themselves. When a broker pays Swaps to their liquidity provider, they are likely to charge more to their traders than what they actually pay. And vice versa for positive Swaps. However, Swaps are a bit more complicated for brokers than they are for traders. This is because brokers have netting account with their liquidity provider whereas most retail traders will have a hedging account.
As an example with nice round numbers, a broker can have 2000 clients, each with a hedging account. 250 clients are long positions of 100,000 EUR/GBP and 1,750 clients have short positions of 100,000 EUR/GBP. If all deals are covered by the broker’s liquidity provider, their account will actually be one sell position of 150,000,000. If the long Swap charged by the broker is -4.9944 and the short Swap is 1.5796, then at rollover, the broker will collect 1247.5 GBP for long Swaps and payout 2764.3 GBP. Not only is this more than twice as much as what was collected, but if the broker didn’t apply any markup on the short Swap they would only receive 2369.4 GBP from their liquidity provider. This means brokers need to factor in the prospect of clients having unbalanced exposure. The primary way to achieve this is through marking up and constant analysis.
Principal Trading and Market Making
So far, we have considered that forex brokers are only middlemen, however, may brokers have trading desks too. Brokers can run an internal order book where they keep orders in-house. They will try and balance clients who are long and short against one another and then hedge with a liquidity provider if the exposure exceeds their risk tolerance. This is known as B-book. They can engage in principal trading, where they don’t execute orders with their liquidity provider right away because they think the market will go another way. Finally, they can become market makers themselves where they run a dealing desk and decide on the quote prices themselves and if they want to fill clients orders or not.
These are all behind the scenes operations that we as traders are unlikely to be aware. Many brokers will engage in these practices as they give the largest profit opportunity. This allows brokers to profit more by not only cutting out execution costs. They can also profit from client’s losses if they get their predictions right and finally they profit from the movements of the market.