Today I want to discuss common brokers' models in order to help start-up brokers to understand the main advantages and disadvantages of each model and to choose an appropriate way of starting their business. There are three main types to choose from: ECN / STP, Market Marker (MM) and a Hybrid model.
The concept of ECN means Electronic Communication Network, it is used to show that the broker is connected to electronic trading system, where competing bids and offers are sent to one pool. Under STP we understand Straight-Through-Processing model, which is used to show that the broker does not intervene in the execution of order, therefore, all transactions are executed electronically with the highest speed. Formally, the MM-broker can also be attributed to this group if execution is made by special software, not manually by dealer.
In traders Forex community it is a widely accepted to reckon brokers that directly send all orders to one or more liquidity providers among A-book brokers. This term includes two models mentioned above. The main advantage of this model lies in the fact that the broker doesn't bear the risks of client' trading and makes money on trades turnover. Therefore it is advantageous for broker when clients don't lose their money and trade more. That is why it is widely accepted opinion among traders that these brokers are more reliable and profitable for them.
Another advantage of this approach is lower cost of the license and simpler regulation. In recent times this has become very important, as traders increasingly began to choose brokers having regulation in certain jurisdictions. Unregulated offshore companies are losing clients and trust.
Unlike ECN/STP, Market Maker– is the broker that doesn't cover positions on liquidity providers and is obliged to pay for client's beneficial trades with its own money –their earnings are clients losses. The general term for them is B-book brokers. On the one hand, this model faces greater risk, but on the other hand, according to statistics, the majority of customers lose their money so usually the revenues of MM-brokers are higher than those of ECN / STP brokers with the same trade volumes. Additionally, if you prefer MM model to STP you will probably need more risk solutions to monitor platform abusers and undertake actions to prevent consequences of such a behaviour. That means spending more money on dealing and special software.
However, you need to bear in mind one more point: if you want to get a license of MM broker in an acknowledged non-offshore jurisdiction, you will need a large security deposit (from 100K to 1 million depending on the jurisdiction), additionally you will have to submit reports to the regulator, that also implies its costs. However, this process can be simplified by the means of technology. For example, our company already has solution for submitting reports to Japanese JFCA (one of the strictest financial regulators). Knowing the requirements of certain regulator we can develop the alike solution for any other jurisdiction.
It is also worth mentioning here, that some of the offshore locations don't have Forex licensing at all. That is why some brokers open a MM-company in offshore, while opening the other one with the ECN/STP license in a certain regulated jurisdiction to gain more customer trust. In this scheme the offshore Market Maker company acts as liquidity provider. This allows a broker to display a license from respectable regulator, but actually to remain an offshore Market Maker with minimal costs.
Many brokers mix these models and pass only part of the clients orders to an A-book execution, the other part of clients is processed by B-book scheme. Here the scheme may also vary: some brokers choose whom to pass to liquidity pool themselves and this happens unnoticeable to the client; others offer separate ECN/STP accounts with a guaranteed transmission of orders to the interbank market.
Let's sum up the main points about two primary models that a broker can use:
It's up to you what model to choose, however you need to understand what target audience you want to attract with this model. This will lead you to clearer vision of jurisdiction and model you want to choose, as well as, accompanying risks and costs to be incurred.
Read my blog on Finance Magnates.
ECN/STP vs. Market Maker brokerage model
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