For those that are ignorant of how forex brokers go about processing trades placed by online traders, it can seem as if every trade made via online platforms, no matter how large or small, gets executed on the vast multi-trillion dollar forex market.
In reality, this is often quite far from the truth, and in many cases, the forex broker is just pretending to place trades for you while betting that you will get it wrong – thereby avoiding the transaction costs associated with actual forex market trading. This is known as ‘market making’, which we shall cover in a later episode of this series, and it’s basically similar to what a bookmaker does when you bet on a sporting event. It’s not necessarily a bad thing, as a good trader can still get the better of this arrangement, and in effect the results may be broadly similar or even beneficial for the trader.
While many forex brokers at the retail end of the market – and if you’re not a professional day trader at an investment bank or hedge fund, you are most likely a client of one of these brokers – operate using this model. Some have tried to differentiate themselves by using other ways of providing access to the markets. One of these, which we shall be discussing today, is known as straight-through processing, or STP for short.
With STP, the broker doesn’t take the other side of your trade, instead placing your order with a third party. This could be any of the other types of liquidity provider, whether it is a market maker, a STP broker, or an ECN broker. This eliminates any potential direct conflict of interest between you and your broker – you just place the trade at the prices provided by the counterparty, and take the profits or losses that come as a result of the changes in price of the financial instrument being traded.
One of the main advantages of this model is that the eventual counterparty does not know who is placing the trade, so in theory any slippage or re-quotes will come as a result of latency, the time it takes between the order being placed and it being accepted by the counterparty.
In practice, this doesn’t always make much of a difference, and the fact that the trade is being placed via an anonymous counterparty provides no guarantee of more accurate pricing or better execution. However, it does provide a greater degree of pricing competition, which should theoretically provide lower spreads and faster execution.
However, it does limit the amount of flexibility that you have in terms of trade size, as most third party trades in the forex market have to be made using standard lot sizes, which means that in high levels of leverage are required in order to execute trades involving smaller stake sizes. While a market maker can offer instant execution with flexible trade sizes, such as mini or micro lots, they have the freedom to make up their own prices.
In practice, the competition between market makers means that these prices are obliged to follow the true market price to a greater or lesser extent, so it doesn’t matter as much as you might think. For those that are suspicious of the motives of their broker, though, a straight-through processing model provides a greater level of reassurance, albeit not without disadvantages in terms of transaction fees and execution times.