How Do Brokers Work? Key Things To Look For And Avoid At All Costs! Which One Should You Choose?

If you are brand new to Forex, you are no doubt wondering how brokers work. It can seem like a minefield. And, if you ask anyone’s advice, you will hear a plethora of horror stories about broker scams.

You understand that a broker has to make money to stay in business. They need to make profits of course. But how can you be sure you aren’t going to give away all your profits to your broker? When it comes to choosing a Forex broker, ignorance is not bliss. You can’t have enough good information in this area.

But you don’t have to worry. Because in this chapter you will learn the key things to look for from your broker. And, you will know how to spot potential warning signs with a prospective broker.

Why You Should Be Careful Choosing a Broker

Not all Forex brokers are created equal. There are hundreds - if not thousands - of brokers competing for you to deposit your hard-earned money. They need YOU to sign up with them, so they can make their money. Sadly, some brokers are outright scammers desperate to take away your money. With their glossy websites and sweet-talking words, it’s hard to spot the scammers if you don’t know what to look for.

In this chapter we will discuss the various types of brokers and why it is important to trade with a trustworthy broker. You will learn the difference between the types of brokers available. And, by the end of the chapter, you will know what regulation means in regards to the safety of your money with a broker.

Forex brokers will tell you they make money from the spread on a currency pair. This is the difference between the buy and sell price. Many brokers only make a small part of their income from spreads. So how do these brokers make their money? Well, would it surprise you to learn that some of them make money by trading against their clients?

Do a Google search on scam brokers reviews (or similar keywords). You will find many horror stories of nefarious tactics by some brokers. Stories such as huge market spikes, wide spreads, and stop hunting are not uncommon. You’ll read about brokers refusing to allow the account holder to withdraw their funds. Some traders even find their accounts closed!

So, you'll agree it's important to have a solid education for finding a good broker and avoiding the bad ones. Don’t commit to anything until you have read and understood this chapter.

Let’s get started on the different types of brokers.

The Two Main Types of Forex Brokers

There are two main types of Forex brokers:

1. Dealing Desk (DD)
2. No Dealing Desk (NDD)

Dealing Desk Brokers (also known as Market Makers)

Do you remember in chapter one, we mentioned market makers? These DD brokers that trade against you are acting as market makers. As a novice trader, it’s natural to assume you are buying and selling from other traders in the market, people like you. The assumption is your loss is another trader’s gain and vice versa. Yes, to a degree this is true. But often the other trader is your broker!

Why is this so?

The fact is that most new traders lose money. The Forex industry has a 95% failure rate. Yes, this is astonishing.  But your broker knows these facts. So, they can take advantage of your lack of experience because they know the odds are on their side. Truth is, at first you may lose more than you win.

Before you sink into a pit of despair, let’s discuss the high loss rate of Forex traders. Is it true that only 5% succeed? Yes, unfortunately, it is a fact of Forex. The reason most traders fail is they do not commit to addressing their shortcomings. Novice traders don’t follow a strategy. They don't have a trading plan or attempt to improve their trading psychology.

Forex is challenging. The truth is most traders aren’t up to the challenge. They want it to be easier and it isn’t. So, they lose their money and give up. And, the brokers know this. Market makers build their profits by capitalising on inefficient new traders. Market makers are filling both the buy and the sell orders of their clients. As they control the price that orders are filled, there is very little risk for them.

Is it right these brokers make money when their clients lose money? Of course not. It’s a glaring conflict of interest, isn’t it? But these are the facts and it's a benefit to know these things.

As a client of a broker who acts as a market maker, you will not see the real interbank market rates. There is no transparency with a DD broker.

The broker’s game then is to recruit hundreds of new traders every day. As traders give up or bust their banks, there are plenty of new traders sucked in by their promises. The brokers may tempt you with special offers, a bonus, and some offer free Forex training. It’s easy to be fallible when you don’t know what you are doing, or what to expect.

At first, you may do well with your trading. But the broker relies on you adding larger amounts of money to your account. They expect you will lose it further down the line.

No Dealing Desk Brokers (NDD)

No Dealing Desks (NDD) brokers do not pass their clients’ orders through a dealing desk. Unlike the Dealing Desks (DD) an NDD does not take the other side of a client’s trade. So, there is no conflict of interest. They simply link two parties together and your order goes straight through to the interbank.

NDD’s make their money by charging a small commission or a small mark-up by increasing the spread.

An NDD broker is the usual choice for a professional trader.

No Dealing Desks can be further subdivided into –

•       Straight Through Processing (STP)
•       Electronic Communication Network + Straight Through Processing (ECN & STP)

Straight Through Processing (STP) Forex Brokers

STP stands for Straight-through Processing. STP brokers make their money from the spread. You are only trading against other traders in the market. STP brokers take prices from their liquidity providers. They do not pass their clients’ orders through a dealing desk.

Unlike the Dealing Desks (DD) an NDD does not take the other side of a clients’ trade. They simply link two parties together. Your order goes straight through to the interbank. NDD’s make their money by charging a small commission. Or they increase the spread and then add a small mark-up.

When you place your order with the STP broker, they pass the order on to their liquidity provider. They retain the difference in the spread. STP brokers usually have several liquidity providers to choose from. This means they can select the best price in the market for them to add a very small mark-up to make their profit. Their mark-up may be tiny, like 1 pip on a currency price. It doesn’t affect you as they make a profit as a broker from these slight mark-ups.

Some STP brokers offer fixed spreads and others offer variable spreads. When you sign up with an STP broker, you will know these details from the outset.

STP brokers have no interest in whether you win or lose. You are only trading against other traders in the market, not the broker. This is good because there is no conflict of interest between broker and trader.

True ECN Broker

The True ECN model is the same as STP in that you are only trading against other participants in the Forex market. You are not trading against the broker. So, as with STP brokers, there is no conflict of interest between trader and broker.

The only real difference between STP and True ECN brokers is that the latter charge a small flat-rate commission on each trade, win or lose. Commission rates are proportionate the size of your trades and account. There is no mark-up on the spreads.

True ECN brokers are popular with traders who run automated trading systems.

So, the choice is yours entirely as to whether to trade with an STP broker or a True ECN broker. Professional brokers use either.

Now let's look at whether to choose a regulated or unregulated broker.

Regulated and Unregulated Brokers

The market is saturated with both regulated and unregulated brokers. It can be challenging to know which one to choose. The last thing you want to happen is to lose your money through no fault of your own, so the below guidelines will help you to understand what to look out for.

So, let’s explore the differences between the two options.

Unregulated Brokers

When a broker is unregulated it means they are NOT licensed with a regulatory body. They have no one monitoring their business. In effect, they have NO RULES or guidelines they have to follow. This means they can take your money and disappear and there is nothing you can do about it. These types of brokers are not uncommon. You will find lists of them online often described as scams or frauds.

Regulated Brokers

A regulated broker is registered with the financial regulatory body of their country. In the UK, for example, this is the Financial Conduct Authority (FCA). Some brokers will hold licences for more than one country

The broker must comply with the given rules of the regulatory body. If the broker breaks the rules, you can lodge an official complaint with the regulatory body.

A regulated broker has to submit evidence of regular audits. They must also submit their accounts on time. To keep their licence, they must adhere to the stringent criteria of the regulatory body.

Why aren’t all Forex Brokers Regulated?

Being regulated adds credibility to a broker. It helps potential clients to see they are a trustworthy operation. Many unregulated brokers operate in offshore jurisdictions. One of the main reasons they do this is because it’s a way of reducing operational costs.

It is costly for a broker to buy and maintain a licence. By a lot, we mean it can be millions. This can be a huge barrier to a start-up broker. Another reason is that many of the brokerages have their base in offshore tax-havens. This way they can limit the burdens of tax. Many unregulated brokers engage in bad business practices.  which result in traders losing their money

The Risks of Choosing an Unregulated Broker

As you can see, you are taking a big risk if you choose to trade with an unregulated broker. You have no protection against poor practice or fraud. If things go pear-shaped you have no recourse. If the unregulated broker went out of business, your money goes with them. If your regulated broker goes bust you can claim compensation from the regulatory body. Of course, there is no guarantee a regulated broker won’t treat you unfairly. But with the stringent rules of their licence, it’s more in their interest to take care of their clients.

How to Avoid Unregulated Forex Brokers

Many new traders end up getting scammed by an unregulated broker. They don’t know the facts you are reading here. They are unaware of the importance of choosing a regulated broker.

ALWAYS take your time when you are choosing a broker. It can help to do review searches. Read all the small print on the broker’s website. A regulated broker will ALWAYS display this on their website. Search online for the financial regulatory body for your country. Then check to see if your broker has a license with them.

We hope this chapter has helped you to understand what to look for when you are choosing a broker. Don’t be in a rush. A little time spent in the beginning making careful checks can save you a lot of heartache down the line.

You can check our recommendations for a broker at https://trading-education.com/brokers

In the next chapter, we are going to look at leverage, a subject often not understood by novice traders.

Next: What is Leverage?