How safe is your Broker?

We all must go through a retail broker to trade stocks, currencies or commodities. Today, I am going to discuss different broking models from the perspective of funds’ safety.

There are primarily four broker types: STP, ECN, Market Maker and a mixture of STP and Market Maker.

STP: STP stands for ‘straight through processing’ and it shows that a broker is routing your orders to liquidity providers without interference in the execution of orders.

Usually, the STP broker has an internal liquidity pool of different liquidity providers (banks, hedge funds, exchanges etc) that compete for the best bid and ask spreads for STP broker orders. The STP broker gives you ‘Direct Market Access,’ by passing your orders directly to their liquidity pool, so orders are filled at the best possible price.

The STP broker earns through a small mark-up in the spread.

ECN: ECN stands Electronic Communication Network, and it means that the broker is connected to a huge electronic trading system of liquidity providers, where bids and offers are received in a single pool.

The ECN broker earns through commissions that that they charge you on trading volume, apart from the source spread and swaps that are paid by you to the liquidity providers.

The major difference between STP & ECN is that STP can choose to deal with different liquidity providers out of their liquidity pool, while the ECN acts as a kind of a joint pool represented by banks, hedge funds, and all the major market players.

ECN and STP are considered similar models because of their direct connection with the LPs. They are also called ‘A-Book’ brokers. They are both considered to be safe because these brokers are not bearing the risk of clients’ trading by acting as their counter party.

Market Maker : Market Makers or ‘B-Book’ brokers’ provide clients with the liquidity to carry out their trades, but keep their orders in-house and do not send them to the real market. They take the opposite side of your trade, so your losses are their wins and your wins are their losses. Here, you are not really connected to the market.

You can understand now that there is an inherent conflict of interest between the broker and the trader in this model.

Brokers like to become Market Makers because the majority of traders lose money, so the revenues are higher for them than those of ECN / STP brokers with the same trade volumes. This also a risky model because if the broker is not liquid enough or cannot manage their books with good risk solutions, they can become bankrupt.

STP/Market Maker Hybrid model: Sometimes brokers use a combination of the A-book and B-book models. For example, they can cover 70% of clients’ trades by routing them to LPs and keep 30% in-house. Those clients whose orders are kept in-house may be inexperienced or have a history of losses.

This model is safer than a pure Market Maker or B-book model but still more risky than STP/ECN.

False STP/ECN Model: There is what I call a false STP/ECN model which may be advertised by some brokers as real STP/ECN where they actually route all their order not to a well known LP, but to another Market Maker broker (which they many even own themselves in an off-shore jurisdiction). Such a broker should not be considered as STP/ECN and carries the same liquidity risk as the other broker behind it.

It’s really important for you as a trader to understand what kind of broker you are dealing with, because not all brokers may be safe. Apart from checking their regulation or licensing, it good to ask questions about which broker model your broker uses, and which liquidity providers (LP) it works with.

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