Choosing a broker: Part 5 – Trade execution

Trade execution is the last factor on this list, but this is because it comes after all the other factors, not because it is the least important. An important question that needs to be answered at this point is:

Who takes the opposite side of the trade?

In trading, in order to execute a trade, you need a counterparty. In order to buy any asset someone has to sell it. Vice-versa, if you want to sell an asset someone has to buy it.

Let’s see what actually happens when you place a trade. There are three options, according to the type of broker:

Trade execution in Market makers

Most retail forex brokers are market makers. This means that you basically trade against your broker. Your trade might not be executed anywhere outside the system of your broker. When you buy, you buy from your broker, when you sell, you sell to your broker. As a result, if you close a profitable trade, your broker will credit your account with the result, and if you lose the result will be subtracted from your account.

Market making is legal and requires higher paid-in capital to obtain a license. By market making the broker provides you liquidity as you always have an opposite side. This means you can make a deal at the quoted prices at any given time. In the process of market making the broker can aggregate numerous smaller orders from retail traders before passing institutional size trades to their liquidity provider. If done properly market making can be a profitable and sustainable business.

Unfortunately, market making can result in a conflict of interest between trader and broker. It is a known fact that the majority of retail forex traders end up losing money. Because of this a lot of market makers can make more money holding the positions against their clients than passing the flow to their liquidity providers. The problem is that this constant flow of fresh retail traders’ money has made a lot of brokers incapable of managing their trading flow properly. Such brokerages don’t like sophisticated clients who are gaining large amounts of money. The effort to handle such a client is too high or beyond the capabilities of their trading desks. As a result, even well-regulated brokers sometimes resort to “tricks” such as poor execution, excess slippage, and platform disconnect to show the winning client that his business is not welcome.

Trade execution in STP/ECN brokers

STP and ECN brokers act only as agents. This means that they don’t take the opposite side of your trades, but transfer them directly up the chain to a counterparty. As a result, the potential conflict of interest in the market making doesn’t exist.

STP stands for Straight-Through Processing. This is a system that allows brokers to transfer automatically all orders directly to a third party.

ECN stands for Electronic Communication Network. This is a system that connects traders, brokers and liquidity providers in an exchange-like environment. An ECN broker transfers automatically all orders directly to its liquidity providers without the intervention of a dealing desk.

The difference between STP and ECN is the exchange-like element. A STP broker is usually connected to one or a few liquidity providers. While an STP broker does not act as a market maker and makes sure all the client trades are covered, it can still control the flow of the orders towards each of the liquidity provider. In the case of ECN, the broker’s platform is connected directly to the pool of liquidity providers (usually big banks such as JP Morgan, Barclays or City) where the liquidity providers compete to get some order flow by offering the best quote. A good ECN broker has connections with many liquidity providers. This results in lower spreads for the end customers, since the ECN system connects each order with the best quote available on the network.

Hybrid model

The hybrid model is not very popular among the general trading public but is well known to the ones who know how trade execution works behind the scenes. In the hybrid model, the broker divides the trade flow into different baskets and sometimes acts as a market maker, sometimes as an STP/ECN broker. In the process, the broker offers true market execution for all deals, regardless of their basket. Brokers which are running a hybrid model can be considered true “No dealing desks” as there is no human interaction in the execution of the trades and handled by an automated system.

If an order in the market making basket is triggered, the system checks the market price (in case of big orders even the market depth) and the client receives the same price which he would have received if the order was transferred to the market.

If an order in the STP/ECN basket is triggered, the system directly relays the order to the liquidity providers for execution and the client receives real market execution. In a true hybrid model, the client does not feel any difference being moved between the baskets.