Types of Forex Brokers and Liquidity Providers
In the OTC FX and CFD trading industry, there are many thousands of brokers catering to a variety of different customer profiles. Since the start of the twenty-first century, the online trading industry has exploded. It’s no longer just top-tier financial services companies buying, selling and trading FX at inter-bank rates. The universal distribution of internet connectivity, relatively high-performance computers in everyone’s homes, easy-to-use trading applications and low-cost derivatives have made the industry appealing to many.
The extent of liquidity takers is incredibly broad. The scope includes retail traders speculating on currencies, consumers with multi-currency e-Wallets, asset managers trading on behalf of clients, businesses hedging risk or another broker taking liquidity. All these consumers need a place to trade. Each of these personas needs its forex administered in a slightly different format. Therefore, brokers catering to those niches employ distinct businesses practices to serve the target client and solve the associated challenges.
Despite there being so many forex brokers in the world, it’s ironic that the phrase broker has begun to lose its meaning. According to Wikipedia, A broker is a person or firm who arranges transactions between a buyer and a seller for a commission when the deal is executed. Somewhere along the way, forex brokers have evolved from solely being middlemen and becoming principals, dealers and agents.
At Scandinavian Capital Markets, we exclusively act as a broker who negotiates terms and connects clients with various liquidity sources, depending on their needs. There is not much ambiguity around that practice, but if you want to understand what we do behind the scenes, read our recent article on how we build the best forex liquidity feeds. In this article, we look at other models (that Scandinavian Capital Markets does not necessarily use) forex brokers use to execute trades and to provide liquidity.
A-Book vs B-Book
Forex broker execution models are very broadly defined as either A-Book or B-Book. An A-Book model executes orders externally, and a B-Book model does not.
A-Book brokers are commonly known as agency brokers, as they simply act as a middleman or an agent. B-Book brokers are known as market makers because they do not connect to the market; rather, they operate an internal market.
In the early days of the retail forex trading industry, A-Book brokers were far more common than they are today. Things have since changed a lot. The A-Book business model became more expensive and less competitive. At the same time, the industry evolved, and new technology and regulations emerged to support brokers with risk management, allowing them to become efficient and responsible B-Book brokers that could ultimately provide a competitive trading environment for retail traders.
When the Swiss National Bank unpegged the franc from the euro, most brokers operated an A-Book model. Most brokers essentially delegated all risk-taking and risk management to their liquidity providers. An A-Book execution model is where a broker uses a concept called straight-through-processing (STP). The trader submits an order to a broker, and then the broker submits it to their liquidity provider.
In 2015 and the preceding years, forex regulation was much looser than it is today. The barrier to launching a broker was not particularly high and unregulated brokers looking to swindle as many traders as quickly as possible were still able to access the same payments and banking infrastructure and lead generation tools as regulated brokers. It was easy to avoid the expected standards involved in operating a sound brokerage, like safeguarding client money, execution policies and record keeping. These bucket shops were able to onboard inexperienced traders and pocket their inevitable losses by running a B-Book model.
It was all boiled down to B-Book brokers wanting you to lose, whereas an A-Book broker is on your side.
Based on this pretence, A-Book brokers have been glorified while B-Book brokers have been vilified. Ironically, the legacy A-Book model did not fare well during the Swiss franc black swan event. The situation unearthed a systemic failure in the A-Book business model.
Since then, brokers have overhauled their risk management processes. As of today, there are many different flavours of A-Book and B-Book execution, and so much ambiguity surrounds forex execution, not just in the retail environment but also at the professional and institutional level.
A-book brokers send their clients’ transactions to “the market”. As the forex market is decentralised, there isn’t a market per se. An A-Book broker can simply pass their clients’ orders to a third party, known as straight-through-processing (STP). Many traders view A-Book brokers as having no conflicts of interest, which isn’t necessarily true. A-Book brokers can execute their customers’ orders in forex marketplaces, or they simply pass them to another party for execution.
A-Book brokers can pass their clients’ orders, known as order flow, to prime brokers, prime of prime brokers, banks and electronic communication networks (ECNs). These brokerages make their money by charging a commission for providing access to the trading environment. They also profit from applying a markup on the spread and swap rates.
A-Book brokers have become increasingly rare in the retail forex trading sector and often cater to investors with more significant amounts of capital. Whilst there is a minimal conflict of interest between client and broker with this type of brokerage, it is more common for trades to be rejected by banks, requotes to occur and for higher costs due to the high level of complexity of this model.
B-Book forex brokers operate a more complicated and opaque business model, and many traders feel they have a conflict of interest because their business model relies on customer losses. While some B-Book brokers operate that way, in most cases, they don’t. B-Book brokers use several techniques to handle their customers’ order flow; they might operate a dealing desk, net long and short exposure internally or hedge with liquidity providers.
B-Book brokers still use a live price feed, usually obtained from a prime broker or an aggregated average price feed obtained from multiple sources, taking prices from several banks, exchanges and market makers.
Trading with a B-Book broker is often very cost-effective as the broker doesn’t pay commissions or fees to liquidity providers, and those savings are passed on. Trade execution is often instant because the firm does not need to refer trades to a third party.
Trade execution methods
Frankly, whether a broker is considered an A-Book or B-book broker is not the be-all and end-all. There can be conflicts of interest in both models. What matters most is the integrity of the broker and how they operate.
Given the distinct difference between these two operating models, there has been a considerable discussion among forex industry pundits and regulatory authorities on how these should be viewed.
Many brokerages use the acronyms STP, DMA, NDD and ECN nonchalantly; these acronyms stand for Straight Through Processing, Direct Market Access, Non-Dealing Desk and Electronic Communication Network, all are characteristics representing the agency or A-book.
Brokers widely used these buzzwords to position themselves as honest and transparent, particularly in comparison to the poor reputation of market makers. In some cases, B-book brokers have echoed these exact phrases in their marketing efforts.
Internal Order Matching (B-Book)
Some large retail brokers have tens of thousands of small trading accounts. With technology, they have found a way to capitalise on this. Instead of using STP to hedge those orders, they can allow those trades to net off internally while still using external reference prices, usually from a liquidity provider. These brokers have essentially developed their own internal order matching engines, or rather offsetting engines. When exposure grows on one side, they simply hedge the risk and scale back the position as the internal book becomes more balanced.
Internal order matching allows brokers to reduce execution costs in the pursuit of achieving a more appealing bottom line.
Dealing and Market-Making (B-Book)
As opposed to using an external price feed to conduct internal order execution, some brokers use an automated dealing desk and generate their own quotes. An algorithm will review each new order and decide how to proceed. The algorithm will either accept the order, requote the order at another price or simply reject it. A market-making algorithm can skew the price in a particular direction according to the size of the firm’s net open position.
A broker operating an STP execution model hedges all client trades with a liquidity provider with which the broker keeps a pre-funded margin account. Some brokers use different liquidity providers for covering other instruments to access the most competitive conditions.
The problem with A-Book execution is that nothing implies who the counterparty on the other side of the trade should be or what sort of execution method should be applied by the receiving counterparty. Theoretically, an A-Book broker can STP clients’ orders to a B-Book broker.
A broker providing direct market access connects traders to a marketplace. Unlike the STP model, where brokers simply pass their traders’ orders to a potentially unknown third party, the DMA model connects traders to the interbank forex market or a forex marketplace (ECN) where an order book is hosted, and level 2 prices are available.
Level 2 pricing is important because it gives traders more control over their execution because they can see price and quantity data, which can indicate potential slippage.
An electronic communication network is a system for buyers and sellers, collectively traders, to trade financial instruments, such as stocks or, in our case, currencies. Because the forex market is decentralised, there are several well-known forex ECNs, such as Currenex, LMAX and Integral.
An ECN broker will provide direct market access to trade in a forex ECN.
Brokers often aggregate liquidity from multiple sources to access the best possible pricing and get more weight behind those prices. There are numerous high-calibre forex price aggregation, and distribution platforms relied on by brokers worldwide. However, due to the fragmentation of the wholesale liquidity sector, aggregation is tricky. Many brokers believe when adding LPs into their network, the more the merrier.
Consider a broker who has two LPs and has deployed capital with each provider. Behind the scenes, they each have the same LP. That means the broker has twice as much liquidity, but half of it is phantom prices.
As mentioned in the introduction, Scandinavian Capital Markets operates exclusively as a gateway to top tier venues and liquidity providers. The various execution models discussed in this article are intended to present a contrast between what we do and what others do.
Not all STP feeds are equal, which is why Scandinavian Capital Markets offers customised liquidity feeds where we consult with clients on what they need. Buy-side firms stand a lot to gain from custom forex liquidity.
There is nothing inherently wrong with any of the models outlined above, they can all have a rightful place depending on the context, and this article did not go into high levels of detail. But one thing is for sure, most brokers do not have systems designed for high turnover trading strategies or firms trading entire clips in one go.
If you want to know how our business model is different from other brokers, one of our relationship managers would be more than happy to elaborate on the characteristics of each execution model and try to give a balanced opinion on the pros and cons of each.