Yesterday I was in Brisbane presenting to a bunch of forex traders from around Australia, several of whom used to be my former pupils a number of years ago and are now trading professionally in a full time capacity. Among the list of core subjects that I covered in my round table was interbank liquidity and price creation, obviously a number of the seasoned traders in the audience knew what I was talking about but it was astonishing to see that allot of forex traders still do not realise just how currencies are priced. So as to fill in the gaps I’ve written this brief review.
As most people which have traded forex already know, forex isn’t traded on an exchange but rather it is traded on an over-the-counter (OTC) basis. Trading over-the-counter is a new concept if you have traded shares in the past as no two fx brokers will be exactly alike, this really is very different to equity brokers who will always show you the same prices. One of several other key differences is that because there isn’t a central exchange when trading forex over-the-counter there isn’t a physical exchange of any foreign currency but rather you are trading directly with the forex provider, which means once you open a position with your broker you can only close it with that forex broker not like trading stocks where you can sell your shares through any stockbroker.
Now that you understand the idea that forex trading is carried out on an over-the-counter basis I’ll start by explaining the basics of price creation. Because of the OTC nature of foreign exchange a good number of transactions take place between investment banks and forex brokers as such they are not reported on a central exchange, it is because of this that price creation in the world of forex is more difficult, however like shares and all markets there are some key players in the forex trading world that make liquidity, these are the investment banks. Investment banks create prices in the course of their dealings with one another and in many cases they’ll quote prices through a system called EBS that enables one bank to see the prices shown by another bank. EBS however isn’t employed by all investment banks, what this means is that there are more banks dealing on prices quoted outside of EBS, essentially their very own market.
So what does this all mean to you? Well this means allot if you are dealing with a market maker or STP provider who will simply offer you a price that they get from one bank or otherwise a price they get themselves that is solely based on the price they obtain from the bank that they deal with this means you may not always be getting a fair price. The excellent news is that there is now an alternative, there are some providers that will show you an aggregated price feed from a variety of investment banks and also allow you to take part in the pricing formation, this means that you’ll be able to place your own bids and offers amongst those offered by several of the world’s largest banks. Brokers that offer this sort of facility are often called ECN brokers.
ECN forex brokers are difficult to come by and operate in a very different way to traditional forex brokers. Apart from the enhanced pricing offered by ECN fx brokers they will always charge commission, for most forex traders this is unheard of however to the astute fx trader this is often a better way to trade. One of the major advantages to paying a commission over a spread is the fact that you really know just how much you are paying your broker, their commission is not concealed within the spread. Paying a commission also means greater opportunity, since you’re paying the natural market price you’re capable of getting choice or even inverted spreads something you would never see with a traditional provider.
Before you all send me a million emails wanting to know which broker I deal with I might as well save some space in my gmail account and let you know right now. Before I let the cat out of the bag I do need to make it extremely obvious that if you look hard enough it is also possible to find a few ECN brokers, just be sure to do your research before you opening a real trading account as you’ll find several forex brokers out there that claim to be ECN providers but are in reality market markers. I have trialled almost all the ECN brokers and so-called ECN brokers and found that there is only one true ECN forex provider and this is also the company that I personally trade with, it’s Australian based provider IC Markets. IC Markets have the very best execution by a long shot and their pricing is one of the most accurate that I have ever seen. As nearly all of you already know I do not promote any particular broker, I just trade with the forex provider that I think has the most competitive product and most transparent pricing and that forex broker is IC Markets.
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