Monday, December 7, 2009

Separating the Brokers from the Bucketshops

Forex (Foreign Currency Exchange) traders invest a great deal of time wringing their hands and discussing their various uncertainties regarding the retail brokers they use to handle their money. Of course it's natural to presume that to make money in Forex merely means to 'beat the market' by finding and executing good quality trades. Sadly, the agency that a client employs can have as much to do with whether or not he wins as anything else.

Bucketshops are retail brokers which take unfair advantage of their traders by taking positions against their clients and sometimes by manipulating the price values they give. Very few companies will own up to doing this, primarily due to the undeniable fact that it gives them a strong reason to make their clients lose. The appellation 'Market Makers' also is often used to denote those agencies who commonly assume the opposite half of their clients' trades. They are creating the market that their clients are trading in, rather than simply sending their trades on to the broader market. A truthful look at the environment of currency, though, shows us that this type of practice is actually vital to making it possible for small retail trades to happen, and though it is often used for illegal purposes, it's not necessarily a nefarious business model.

The reason for this is because there's no physical 'Forex market', in the way that there is for typical kinds of trading. As an example, commercial stocks are available only by way of typical stock exchanges -- the NYSE being among the largest. Exchanges like these are governing agencies that qualify each corporation to be listed, define the terms of the acceptable trading contracts, keep an eye on brokers, and finally clear all trades financially. Stock exchanges establish the daily hours of business and have the authority to decide whether any stock or brokerage should be delisted or shut down as a result of policies that run the risk of compromising the market at large. They exist at actual physical addresses and are themselves regulated by government offices.

The Forex market, on the other hand, is made up largely of giant organizations that need to swap capital with other nations. The real Forex market is made up of giant multinational corporations and international banks that transfer currency from place to place in order to facilitate global trade. If a Japanese company sells products in America, it will likely be paid in the form of US Dollars, but it have to pay its internal costs in the form of JPY, such that it must be able to convert significant amounts of currency on a consistent basis. Companies like this and the banks they use to exchange the currency are the real market, and small time traders are incapable of being involved at this level; they simply don't have the huge sums of capital that would be of interest to the major currency players.

That's the reason why Forex brokers trade with their own customers. The brokers create manageable trade opportunities for the small time guys (that's us) who might not ever be able to participate in the Foreign Exchange market. Then they make bigger offsetting trades on the open market via agreements they have with 'Liquidity Providers'. By ourselves we could never be able to attract the attention of the major banking institutions. It simply would not be reasonable for them.

Because of this, the trader depends on her broker to provide their own currency prices rather than receiving a unified price from a central exchange. Each broker does trades with their specific liquidity providers and different brokerages can be expected to employ different banks. Those differences are apparent in the variation between broker quotes. From this truth arises the requirement for a broker to make the market for its customers, not purely from a want to defraud them (though some few most likely do). A broker can be upright and still have the need to trade opposite its clients, even though they're not attempting to mess with prices and make those clients lose.

So we can see, with regard to most trades a typical broker will be forced to 'trade against' their clients, though they are required by law and ethics not to do this in a way that harms them. This sets up a serious case of 'caveat emptor' - let the buyer (and especially those looking to learn forex) be careful. It's crucial to always keep a close watch on the quoted prices and trading practices of their agency, and to select that brokerage sensibly. It would be unjust, however, to assume that a broker who takes the other side of a client's trades is doing so to screw them. It might seem strange and also somewhat distressing, but it's a fundamental and important part of the small capital foreign currency exchange business model.

1 comment:

  1. I'm still not clear about one thing: if all brokers trade against their small clients, what distinguishes the "bucketshops" from all the other brokers? Is it just that the bucketshop brokers themselves are so small that the only way they can make money is to punish their clients by using devious tactics against them? Surely the profit they make from the spread should be enough to keep an online broker happy? After all they are just middlemen, their overheads are low compared to "real-world" brokers, and once they get a bad reputation as marketmakers their clients will start deserting them. It's not hard to find out who are the good and bad brokers by going to the various independent forums on the internet. Why would anyone use the services of a bucketshop unless they are just newbies who don't know about these things? Seems to me that if the brokers place their own trades they it is up to them to know how to place them rather than simply blindly trading against their clients. They are just as certain to win as lose taking that approach, partly because the market is unpredictable, and partly because a lot of traders themselves don't have a good trading strategy. Seems to me though, that the more successful traders are most likely to be targeted by these bucketshops as they are the ones with the healthiest trading accounts for these scoundrels to plunder. Doesn't sound like ethical business practice to me. Hopefully more people will become aware of this practice and who the prime offenders are, and punish them by taking their business elsewhere.