Without a forex broker, retail trading would be challenging, if not unfeasible. Brokers play a crucial role in facilitating the convenience of trading currencies at a large scale in milliseconds. Like any business, this privilege comes with considerable effort, for which they should receive compensation.
Knowing how brokers make money will help clients understand their role better and how the brokerage industry works overall. This article will cover how the average broker makes money and the age-old question of whether they trade against their traders and whether that impacts clients.
Defining the main role of a forex broker
Before we dive into the revenue streams of the average forex broker nowadays, it will help to appreciate their role. This should give us a better understanding of how each income source is derived.
A forex broker is fundamentally the middleman between the interbank market and the client. They provide a running trading platform allowing traders to buy and sell currencies. Some may wonder why clients can’t trade straight through to the interbank.
The main reason is this group trades astronomical sizes, typically millions of units of currencies, which are far too large for the average speculator. This disparity spawned retail trading, where the barrier to entry was lowered considerably, allowing for much tinier accounts to still profit from trading.
The interbank is really the forex market in a nutshell; they are the liquidity providers. This group sells currencies to many exchanges, brokers, and other forex dealers. Of course, like any financial institution, these deals incur fees, leading us to the next point on the broker’s primary income source.
The main revenue stream for forex brokers: spreads, commissions, and swaps
Now that we know the basics of the relationship between brokers and liquidity providers, we’ll cover the main revenue streams.
Spreads and commissions
Whenever a trader executes an order on their trading software, it typically passes to the broker, who then directs it to any available liquidity provider.
In return, this dealer sources the requested currencies in the position for a small fee. The broker will then apply their mark-up of a few pips to their trader, also known as the spread. This is usually their main income source because of its high recurring nature, depending on their brokerage model (more covered later).
If a broker processes thousands of positions daily, spreads can accumulate to substantial amounts, making this model attractive. However, some might be confused over when a broker applies a commission.
When spreads are floating or variable, the broker is technically not supposed to apply a commission. However, a commission is allowed if the broker offers fixed or ‘zero’ spreads. It is rare nowadays to find brokers charging both fees or marking up spreads unless they are naturally unscrupulous or unregulated.
Fortunately, such costs in forex have become a lot cheaper and consistent across the board.
As forex is highly leveraged, swap interest applies, but only when a position is held overnight. The extent of the swap depends on the swap rate quoted by the interbank, the interest rate differential, and whether it was a buy or sell order.
If the interest rate differential for buying USD/ZAR is negative, the broker debits a swap for every day the order ‘rolls over’ or is active at the start of a new trading day. Conversely, if this order were instead a short position, the broker would be paying the swap to the trader.
Other revenue streams for forex brokers
The following streams aren’t as significant but will have some influence on a broker’s bottom line.
Deposit, withdrawal, and inactivity fees
An increasing number of brokers have offered fee-free funding and withdrawals through various card and e-wallet options. Yet, a few might still apply a small fee, which is completely legal.
Bank wire transfers will almost always incur a charge from the processing bank and the broker itself above a certain amount. In addition, some brokers might also charge a monthly inactivity fee like $5 if an account remains inactive over a defined period without any trading.
Do some traders trade against their clients?
This topic continues to be contentious in the trading community and is largely misunderstood. Brokers generally fall into two camps; direct market access (DMA) or STP (straight-through processing) and market makers (also referred to as dealing desk or B-book).
There is also a favorable perception towards DMA brokers as they are believed to send traders’ order ‘straight through’ to liquidity providers without interference, while market makers are often viewed negatively due to the perceived interest conflict.
The short answer is yes, a market maker is technically trading against their clients, but not in a negative way. In reality, there will always be a counterparty in forex because, for every buyer, there has to be a seller and vice versa.
Also, there is no true method to know where one’s orders go through as a retail trader because of the decentralized nature. It is more likely brokers using both systems nowadays at any one time for various reasons.
Some brokers opt for the market maker model to offer quicker trade execution, fixed spreads, lower-sized accounts, etc., most of which are not possible with the interbank trading larger volumes and variable spreads.
There are more financial incentives for using this mechanism, but also some considerable risks A conflict of interest leading to price manipulation is also possible with a market maker broker, but only if they are unregulated.
While most brokers are reluctant to admit they utilize this system, it’s nothing to worry about for the retail trader, provided the firm is appropriately licensed, reputable, and fosters reliable execution.
Hopefully, this article has shed light on the business model of forex brokers and a few ideas of what goes on behind the scenes. On the whole, spreads, commissions, and swaps make up the majority of the average forex broker’s profits.
Market makers brokers are more common than most traders assume, which is also another earning avenue. But, conversely, it does carry risk since any profits made by the client come from the broker’s pockets.
Despite the generally negative perception some may have on how brokers conduct their business, most brokers stand true to their word and act ethically, which is especially true for regulated ones.