ECNs versus the Market Makers: Who’s the king of the hill?

The topic du jour among forex traders, both apprentice and journeyman alike, is which is better, the market makers or the ECN?  To answer that, we first have to make a decision as to what exactly is our ultimate goal.  And once we’ve got that defined, we need to explore the differences between the ECN and the Market Maker. 

A Little Background Information

Everyone has a complaint about their broker; there are almost as many broker jokes as there are lawyer jokes, and that’s saying something.  Lately, largely because of the state of the global economies (i.e. some bad and others worse), the issue has escalated tremendously.  Bear in mind, most people don’t like change, but that’s pretty much all that’s been happening.  We’re in a state of flux, and when change happens, you will hear whining and complaining, ad nauseum.

Thanks to the internet, investors are getting economic data from around the world almost instantaneously.  Every nuance, gesture and word uttered by a central bank official or finance minister somewhere in the world is carefully scrutinized and a new retail trading strategy put in place as a result.  There is the potential for tremendous profit taking, and everyone, even the little guys, wants to be in on the game.    

The Market Makers' Quandary

The question is do ECN style brokers know something everyone else doesn’t?  The answer to that question lies in the liquidity provided by the market makers, and the interaction between them and the global inter-banking market system.  The answer is also complicated by the relationship dynamics, which are so varied.  Generally, though, this explanation should apply to the majority of retail brokers.

It’s a fact that a retail broker is a party to all foreign exchange transactions.  Here’s an example that should offer some clarity.  On the forex exchange, Jack sells while Margaret buys; the exchange broker receives his cut for introducing Jack and Margaret and facilitating the transaction.  At FamousFX, whether Jack is buying or Jack is selling, FamousFX is the counterparty to his trade.  FamousFX has a couple of tricks up their sleeve; they can cover Jack’s position through their own liquidity provider, or they can put the trade into the pool and then cover their position through their liquidity provider equal to their own position, or they can just hold on to Jack’s position, assuming that Jack is probably going to take a loss, anyway.  Whichever action they take, there’s only a single movement, or at most two, in the ECN type of environment, between Jack and the other party.

The difference between these steps is where the problems lie, especially for Jack’s market maker forex broker during times of high volatility trading.  Say a central bank somewhere issues a press release that causes great upheaval in the market.  Jack’s broker has made some serious promises to him, in an effort to keep him a happy customer.  They may have bandied about the words, “guaranteed fills,” or “zero slippage” or even “fixed spreads.”  But then, the dreaded thing happens:  Change.  The clients of FamousFX begin trading on the news that precipitated the change.  Fortunately, market reactions tend to be quite predictable and the clients of FamousFX know this, so they’re all pretty successful with their strategy.  Unfortunately, for FamousFX, it appears that their own business model isn’t working the way it should, and they are losing money hand over fist during the release of the economic news.  And the reason that they’re losing are those couple of steps between Jack and the bigger market.  You see, FamousFX is selling the relative currency to Jack, as well as thousands of their other clients, at a time when no when else would do it.  Naturally, if no one wants to sell to Jack, no one is going to sell to FamousFX, either, and so FamousFX can’t cover their trades.

What other options are available to FamousFX?  Simply put, FamousFX is going to have to widen their spread, or introduce some slippage, or just close down whenever there’s an impending data release.

The ECN:  Saving Grace of the Forex Trader?

As the fairy tale goes… One day, something amazing and exciting happens.  A new player in the forex game arrives, and he’s spouting promises left and right.  You know the drill:  “We’ll never take a position against you” or “Low, low spreads!  Only 1 Pip!” or even, “Absolute Inter-bank access.”  Almost as many promises as you’d get from a used car dealer.  But, as a trader, you’re excited, and can’t wait to play, so you take a demo for a quick spin around the market.  “Woo Hoo!  This is sweet!” you’re thinking.  At first.  Then, all of a sudden, it’s not really what you had expected.

The ECN Way

Now, if we could just be honest with ourselves for a moment… our expectations are based on what we think we know.  The truth is that the majority of traders just don’t know what it’s like in the “real” market.  We expected that the ECN brokers would be a lot like the brokers we knew of old, but without being ripped off by the dealing desk, and with the benefit of some tighter spreads.  What a let down.

Did you notice while you were playing or trading with your ECN account that there’s still slippage?  You thought there wouldn’t be, didn’t you?  Sorry.  Within a true ECN environment there’s going to be something akin to slippage, but the word for that hasn’t actually been coined yet.  The truth is you are merely getting exactly what you asked for.  If you decide to go long on a currency like the Euro and put in a market order, then that’s what you get.  The ECN environment isn’t like grocery shopping in the supermarket and paying the sticker price on a can of beans; it’s more like going to a flea market, putting in your offer and hoping for the best.

What makes us think it’s like shopping in a supermarket?  It’s because FamousFX and his friends have brainwashed us into believing it.  Forex traders have been spoiled by the simplicity of retail brokers; they want to make it as simple as supermarket-style, one-stop-shopping.  And they play off our ignorance of how the market really works to better their own profit margins.  It’s no wonder that forex traders have become such a suspicious and cynical lot.

In the real market, i.e. the Inter-bank network, a market order is a market order is a market order.  A trader’s request for a currency at a market price is simple enough to comprehend.  What’s not so simple to comprehend is the swiftness in the movements of the market.  In the split second between your brain’s decision to buy or sell a currency at a specific price, and the pressing of your finger on the keyboard to put that market order in, the price changed.  Just like that.  Your market order for a Euro at 1.3520 hits the “real” market, when a seller of that Euro is sitting at 1.3720 or even higher. 

There are very few people stupid enough to be willing to sell their Euros in the seconds after Mr. Bernanke issues his economic report on the declining state of the U.S. economy.  “Uh, thanks, but no thanks.  I think I’ll just hold onto my Euro for the moment, and you can keep your crumbling U.S. Dollar,” will be the likely thought of the smart traders.

The reality of the ECN styled market is this:  Sometimes, there just may not be anyone buying at the price you’re selling, and vice versa.  This may be hard to accept for some traders, who will feel cheated when they expected better from the ECN guys.  “They’re all cut from the same cloth,” is probably what they’re thinking.  In fact, they are only getting what they asked for. 

No doubt, after only a couple of days on your ECN style platform, you’ll get your first glimpse of how things work after an economic report has been released.  You’ll be gladdened to see that you’re not getting those absurd fixed spreads – pips of 20, 30 and even up to 50 – like the kind you’d get from your old FamousFX platform.  But, what will eventually throw you for a loop is the frenzied spreads you will see – widening, narrowing, even inverting at some point.  Scary stuff; especially in the few seconds before a press release comes out.  You can bet that banks are pulling their orders and last second speculators are standing at the ready.  It’s a dangerous world.  But it’s closest to how the inter-bank network really works.  Kind of like an aerialist working without a net.  You won’t find any guaranteed stop losses on the ECN platform.  You’ll only find real buyers and real sellers and transactions of whatever the market can and will bear.     

What about commissions?  Well, your ECN broker has to make a profit, right?  So, they will charge you a commission or fee for each transaction.  That’s pretty clear, unlike FamousFX who hides the broker profits between the price of the liquidity provider and your price.  And while commissions and fees will vary among them, generally most of the ECN brokers charge 1 or 2 pips for each round turn, of course dependent on the currency paired.  Your ECN broker has to show a spread of a pip or two (or less) as compared to the old market maker broker you used to use.  But are the net spreads from your new ECN broker better than FamousFX’s?  The answer is Yes.  And no.

So, what’s the Big Deal about ECNs?

If the answer is yes and no, then what’s the big deal?  Simply put:  Transparency. Or, perhaps more aptly put, the promise of transparency.  Some investors may initially be attracted by the spreads, but the real reason that so many traders like ECNs is the chance to see how a real market operates.  There’s no lying or cheating; what you see is what you get.  For a lot of us, that’s all we really want:  A fair trade. 

Bear in mind, though, your old retail trader wasn’t necessarily out to cheat or lie to you.  It’s just that their business model doesn’t actually inspire confidence.  Add to that the frequent and numerous media reports of brokers who practiced all sorts of illegal doings, and you’ve got a market full of traders and investors just begging for transparency. 

That’s not to say that all ECN brokers are honest and/or transparent.  The fact is, until we’ve got a central clearing function that allows everyone access to the feeds, it’s not really transparent.  It is, however, a move in the right direction.

Anxious to Open an ECN account?  Think Carefully.

Are the old market maker brokers dinosaurs, then?  Of course not.  Many brokers like FamousFX offer features which just make it prudent or advantageous for new or smaller account traders.  For example, some guarantee that you’ll never have a negative balance, meaning you can’t lose more than you’ve got in your account.  Actually, this is a very prudent, very wise safety feature.  And ECN brokers just can’t offer that.  That alone makes it the best choice for a lot of traders.  Consider the leverage aspect of it, too.  Market maker brokers can offer leverage of sometimes 400 to 1, and if you need leverage like that it’s best to have protection against negative balances.  Finally, a lot of traders like the advantage of the fixed spread, especially if they’re trading in the Asian forex markets. 

So, ECN Brokers…or Market Makers?

Hopefully, you’ll know have a better idea of how each type of broker is structured, and what are their specific advantages and disadvantages.  Active foreign exchange traders may likely be more satisfied with an ECN styled broker; a new trader might prefer the simplicity of a well-qualified market marker broker who employs the requisite safety features.

Better or worse?  It’s really a matter of personal choice and personal needs. 

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