For all traders, one of the most important things to consider is what type of broker you are going to deal with. All brokers are not the same, and it is worth considering the two main (and completely different) business models that brokers use – ECN Vs Market Maker. Today you will learn about the two models, the benefits they offer, and how to work out which is best for you.
An electronic communications networks (ECN) broker is a financial intermediary that gives clients direct access to other participants within the equity and currency markets. An ECN broker consolidates price quotations from several market participants, so it can generally offer its clients tighter spreads than traditional brokers. An ECN broker only matches trades between other market participants. The broker cannot trade against the client.
When a broker employs a market maker model, however, this involves a firm or individual quoting two-sided markets in a particular security, providing bids and offers (known as asks) along with the market size of each. A market maker buys and sells securities for its own account and is generally compensated for the risk of holding assets, as the value of an asset may decline between its purchase and sale to another buyer.
Is ECN a better option than Market Maker?
If you trade with an ECN broker, your trades flow directly to the best price offered by a liquidity provider without price manipulation from the broker. ECN forex brokers aggregate a list of all the best bid and ask prices from liquidity providers or the interbank market (usually major banks and financial institutions). They then match trades with the best prices and lowest possible spreads without considering the source.
Unlike fixed spreads, which some market makers offer, spreads of currency pairs vary on ECNs, depending on the pair’s trading activities. That means during periods of high trading activity, some brokers will offer no ECN spread, especially in the more liquid currency pairs such as the majors and some currency crosses. If you see a broker offering zero spreads or spreads ‘from 0.0 pips,’ it will generally be an ECN broker.
An ECN forex broker can be seen as a middleman between buyers and sellers with no interest in interfering with or manipulating prices. The broker makes money on the spread, meaning they want active, profitable traders that will continue to trade over the long term. Electronic networks also make money by charging customers a fixed commission on each transaction, so it is vital to be aware of the fees.
On the other hand, market makers basically “make” the forex market on top of the actual market, and your orders rarely reach the real market. Unlike the ECN broker, who feeds orders directly through to a liquidity provider offering the best price, a market maker may be more incentivised to offer you a set price, which may not be the best price available, due to the conflict of interest.
If you are trading currency pairs with a market maker, you do not get direct access to the underlying liquidity which makes up the forex market. Brokers following the market maker model are also referred to as ‘dealing desks’. The broker does not directly reflect the market, as the broker or dealing desk is in charge of defining the exact prices being quoted.
Market makers act as counterparties to each forex transaction in terms of pricing, which means they must take the opposite side of your trade. In other words, they must buy from you whenever you sell, and vice versa. This puts you in the position where the broker you are using technically wants you to lose! This can lead to price manipulation and stop hunting in the worst-case scenarios.
The exchange rates that market makers set will obviously be based on their best interests. They generate profits through their market-making activities via the spread charged to their customers. The spread is the difference between the bid and the ask price and tends to be fixed by each market maker at a level that works for them. Spreads are typically kept at a reasonable level due to the intense competition between the various market maker brokers.
The Benefits of ECN
The leading true ECN brokers use the best technology trade servers, such as NY4 & LD5 data centres in London and New York, which are connected via fibre optics to their ECN network and liquidity providers, ensuring lightning-fast execution. The advanced price aggregation means increased pricing transparency, lower or narrower price spreads, no slippage and the fastest possible trade execution. Trades feed straight through to the best price available without interference from a “market maker”.
Authentic ECN brokers do not involve themselves in making or setting prices which in turn reduces the risks of price manipulation for retail traders. However, ECN brokers need to make money, too, so you will find there is generally a fixed commission charged on each transaction. As a trader, you must look closely at the pros and cons of using any particular broker. You will often find that the combination of a small commission and a tight spread makes trading with an ECN broker cheaper than with a traditional market maker broker. ECN brokers generally offer affordable trading costs, transparent pricing, better spreads, round-the-clock trading, and a certain degree of anonymity.
The Benefits of Market Maker
Those brokers who follow the market maker model, by definition, trade against their clients, which means that there is a fundamental conflict of interest involved. However, this does not mean that there is anything inherently wrong with trading with a market maker or that you will automatically be worse off trading with one. Despite many traders preferring an ECN broker vs market maker model, it should be remembered that, in the global markets, market makers fill a useful role. They are there, always willing to sell or buy, provided the trader is willing to get involved for the right price. They create liquidity on the one hand and contribute to market efficiency on the other.
Often market makers offer to trade with no commissions and fixed spreads, so the price per trade is easy to calculate. Currency price movements can also be less volatile with market maker brokers compared to currency prices quoted on ECNs. There is the potential for fast executions if the broker uses low latency servers and often a lower barrier to entry. Market makers can form a bridge between the interbank market and retail forex traders by buying significant positions from the liquidity providers, which they can sell to their retail clients. This allows currencies to be broken down into smaller lots that may be better for retail traders with small accounts. In this way, the broker effectively creates a new market alongside the main forex market that might better fit retail traders’ liquidity positions.
Which One Should You Choose?
Traders should always carefully consider their choice of a broker before committing, as the type of broker you pick can significantly impact your trading performance. Trust, reputation, regulation and business model (that is, market maker vs ECN) are important factors in a client’s decision-making when choosing a broker. It is essential to do your research properly.
Many traders prefer ECN brokers as they feel there is complete transparency, and the broker is working on their behalf to match them with liquidity providers. With a market maker model, there may be the feeling that the broker is working against you as they are on the other side of every trade. However, some traders may prefer the pricing model with a market maker, which is generally commission-free trading, with all broker profits coming from the spreads.
As currency price movements can be less volatile with the market maker models compared to currency prices quoted on ECNs, this may suit risk-averse traders somewhat better. However, this lack of volatility can be a disadvantage to some traders, such as scalpers. In fact, market makers may discourage scalping and even put restrictions around it, which can prevent scalpers from getting their orders filled at the prices they want.
Ultimately, when assessing the ECN vs market maker business model, a lot will depend on the individual trader and their needs and preferences, especially regarding pricing models, liquidity, trading techniques and strategies, and appetite for risk. While many traders prefer ECN brokers, plenty of market maker brokers remain popular because some traders see the advantages of this type of broker.
In addition, when choosing a broker, there are many more things to consider than just the market model. Traders will generally make decisions based on multiple factors, including the trading platforms available, different account types offered, the minimum deposit required and the ease of account set-up, funding and withdrawal.