One of the most important aspects of trading, for both traders and brokers alike, is how trade orders are handled. When a trader places a trade order in his trading platform, where does the trade order go? The trade order first travels to the broker with which the client is trading, but then the broker may pass on the trade order to a “liquidity provider.” That liquidity provider may in turn send the trade order to another liquidity provider, and so on. Alternatively, the first liquidity provider can “take risk” on your trade order which the broker sent to them.
Understanding the concept of “taking risk” on a trade order is critical to your success as a trader. If your broker is taking the other side of your trade order and not passing it onto a liquidity provider, your broker is taking 100% of the risk associated with your trade order. Simply put, if you make money on the trade, your broker will lose money, and vice versa. Your broker making money while you lose money is clearly a conflict of interest. In this situation, your broker has incentive to make you lose money. This is bad for several reasons. First, they may give you bad advice by encouraging you to use excessive leverage in the hopes that your account will receive a margin call. Second, they may manipulate the conditions of which your trade order is executed. Brokers have software that allows them to add “slippage” (the distance your trade order is filled away from the market rate) and also to delay the execution of your trade orders by a certain amount of time. On the other hand, if your broker is passing all of your trade orders they are receiving on to a liquidity provider, your broker is taking 0% of the risk associated with your trade order. In this case, your broker has incentive to try to help you to make money. If your broker is not taking any risk on the trade, the only way they are making money is by “marking up” the spread and/or adding commission. Thus, the more trades you execute, and the larger those trade orders are, the more money your broker makes. So the ideal situation for your broker is for your account to grow in size, as what typically happens is that the size of your trade orders will increase as your account balance increases.
Another way a broker can handle your trade orders is by matching them up against trade orders from the broker’s other clients. This is typically known as “Electronic Communication Network” or “ECN” trading. In this case, all of the client’s trade orders will never perfectly match up together, so there will always be some whole or partial trade orders that the broker will have to hold while they wait for a new client trade order to match up with them. So the broker has incentive for their traders to lose money, but to a much smaller degree than a situation where the broker is strictly running a B-Book. Typically, a lot of unregulated retail FX brokers use the term “ECN” for marketing purposes, even though they don’t actually offer ECN trading.
Definitions:
A-Book/STP: “Straight Through Processing” is when a broker passes the trade orders it receives from its clients onto a liquidity provider. In this case, the broker only makes money from a spread markup and/or commission on trade orders. It does not make or lose money as the client loses or makes money.
B-Book/Dealing Desk/Market Maker: when a broker does not pass the trade orders it receives from its clients onto a liquidity provider. In this case, the broker makes money as the client loses money and loses money as the client makes money.
ECN: “Electronic Communication Network” is an internal system by which a broker matches a client trade order up with trade orders from other clients. The clients of the broker are essentially trading against each other AND against the broker.
DMA: “Direct Market Access” is largely a marketing term with no practical application in the retail FX industry.
Slippage: The difference between the price shown on the broker’s trading platform at the time you clicked to open the trade order and the price that your trade order actually was filled at.
