Monday, December 7, 2009

Bucketshop or Honest Broker - Can You Tell?

To a lot of Foreign Exchange clients, few things cause more consternation than their choice of an online broker. The prevailing assumption is that whenever you try to make money in forex trading you are plying your ability against 'the market' and that's the only enemy you should be thinking about. Sadly, the broker that a person uses will have as much to do with how much success he has as anything else.

Many traders stay away from so-called Bucketshops; companies which give inaccurate prices, appear to manipulate them for their own gain, and actually work to the detriment of their clients. Very few companies will admit to having such a policy, primarily because it provides them a strong incentive to make their clients lose. A different term used for this kind of agencies is 'Market Makers'. These brokers are making the market that their clients trade in, instead of simply relaying their trades on to the broader market. A truthful examination of the environment of Forex, though, shows us that this kind of practice is actually necessary to making it possible for small retail trades to happen, and although it As unsettling as these truths may are, small capital trading would be unfeasible were it not for there kinds of practices, and not all companies use them to cheat their customers.

To understand why this is true, one must start with the understanding that the 'Forex market' is very dissimilar to typical investment opportunities in that it isn't actually there in a real-world sense. Stocks for companies, as an example, are bought and sold on a physical exchange such as the New York Stock Exchange or the AMEX in the USA. These exchanges are governing bodies that qualify each corporation to be traded, lay out the specifics of the standard trading contracts, monitor brokers, and finally clear all trades financially. They have a specific address, do business at predetermined hours and are given the authority to shut down trading of any and all stocks or the trades of any broker whom they feel are acting unlawfully or in a way that hinders fair and legal trade.

On the other hand, the Foreign Exchange market is just the aggregate trading of corporations who desire to transfer cash from one specific currency to another. The actual Forex market is made up of giant global corporations and international financial institutions who transfer money around in order to manifest global trade. Suppose a corporation from Australia markets some goods in Canada. The money will come as Canadian Dollars, but the company will need to pay for its costs in Australian Dollars. It will require a convenient way of converting its funds almost each business day. This is the real Forex market; businesses and banks who move trillions of dollars worth of currency back and forth on a daily basis. Small time traders like us could never trade in that arena -- we clearly can't access that much money.

Because of this a Forex broker must be free to buy and sell currency directly with their clients. Brokers provide small trading opportunities for the little guys (like us) who might not ever be able to trade in the Foreign Exchange market. Then they turn around and make much more substantial transactions with their 'Liquidity Provider'; a bank willing to transact with brokers for the purpose of making some profit from us retail traders. With our tiny accounts we'd never be able to catch the eye of the large banks. When a broker bundles our trades together, trading opportunities abound.

As a result, the trader must rely on their broker to provide their own currency prices instead of receiving a unified value from a central exchange. Each broker executes transactions with their specific liquidity providers and different brokerages are likely to use different banks. These disparities are evident in the disparity between broker quotes. It is not an attempt to cheat the clients (although some unethical brokerages likely do) it is merely a necessary part of opening the market for small traders to participate in. A broker could be ethical yet still have the need to trade against its clients, even though they're not attempting to misquote prices and make those clients lose.

So you see, with regard to many trades a retail brokerage will need to 'trade against' their customers, though they are required by legal and ethical conventions not to do so in a way that harms those customers. This creates a significant situation of 'caveat emptor' - that is, let the buyer (and those hoping to learn forex) be careful. It is crucial to always keep a close eye on the price quotes and trading practices of their brokerage, and to select that broker prudently. It would be improper, however, to presume that a broker who takes the other side of a client's trades is doing so to screw them. It might sound bizarre and also a trice disquieting, but it is a necessary and crucial part of the small capital foreign exchange business model.

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