Difference between ECN, market makers and STP Forex brokers
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The stock market is a heavily regulated industry where prices for stocks are derived from a central exchange such as the New York Stock Exchange (NYSE). In the Forex industry things work slightly differently. Firstly, the Forex market is not as heavily regulated and secondly, prices are not derived from a single, central exchange. Instead they are derived from something called the Interbank market.
This is a collection of large hedge funds, banks and third party financial institutions that provide buying and selling prices for currencies to Forex brokers around the world. Actual prices provided will vary depending on the relationship between the Interbank market participants and the Forex brokers in question. The better the relationship the better the prices supplied. However, for the sake of our video tutorial and example, we are going to assume that the Interbank market participants are the same and that the currency prices supplied to brokers are also the same.
Let’s say that the Interbank market is providing a price for EUR/USD at 1.4000/1.4001. The difference between the buying price on the left and selling price on the right is said to be a 1 pip spread.
ECN broker will take that 1 pip spread and add another 2 pips onto it to make the total a 3 pip spread. So the price they are quoting now is 1.3999/1.4002. This is how they make money from you.
Market maker broker will also take the original 1 pip Interbank market spread but they will add 1 pip on top to make a 2 pip spread total. The purpose of this is to undercut the ECN Forex brokers. At this stage it is the market maker that is more favourable.
STP broker will do both of the above, depending on their customer base. They will provide a 2 pip spread to unsuccessful traders and a 3 pip spread to successful traders to ensure they make as much profit from them as possible.
Trading market conditions
This is where the game changes. Despite being more expensive, the ECN broker will provide true market conditions. Simply put, the trading conditions in the Interbank market will be exactly the same as the trading conditions on the ECN broker’s platform. This is fair.
The market maker will manipulate market conditions in their favour in 2 ways:
- They will place exactly the same trade as you in the Interbank market at the same time. Once you hit your profit target you will receive your winnings but they will be the winnings that the market make made in the Interbank market. All they will do is pass their winnings onto you so that they do not have to take money out of their account. In fact, they might make profit from you on a small commission charge, if they charge one.
- They will use something called ‘virtual dealer plug-in. This piece of software allows them to trade against you. Why would they do this? Every time you trade, you put your Forex broker at risk. The way that they manage their risk is to ensure that you lose now and then. If you are a successful trader, you are losing them money. So, by placing a trade against you that will stop you out, they guarantee to make a profit from your loss. It sounds unfair and it is, but the reason why they can get away with it is because the industry regulations are not tight enough. It is improving every year but at the time of writing this article, we are not there yet.
Do not be put off by market makers; most of them are actually really good Forex brokers. However, there are the odd few that will take you for a ride and the best way to notice this is if you see huge market spikes going against you but no economic news is due out. Also, if you are really successful in your demo trading account and the same Forex trading strategies are used in the live account but you generate a loss; the time to be suspicious is here.
STP Forex brokers will again, use best of both worlds. They will use automation or manual labour to split their users into good and bad trader brackets. Bad traders will most certainly be dumped into manipulated market making conditions while good traders will be promoted into the true market conditions. However, they will have to pay a higher spread premium so that the broker makes as much profit from them as possible.
If you are still stuck to find a good broker then take a look at our Forex brokers table. The table includes a list of approved Forex brokers so have a look and you will hopefully find the one you are looking for.