When most people hear the word “broker,” an inaccurate image often swims into their minds. They imagine a professional individual sitting in a bank, buying and selling stocks for his or her clients. While you can still find broker services that give their clients investment advice and manage their portfolios, when we talk about brokers, we are referring to online brokers.

Online brokers serve as an intermediary between you and the market exchanges in return for a commission.

There has been a record-breaking increase in online brokers opening their doors to retail investors. And you will find that there are two main types of brokers: those who put your order directly in the market exchange, and those who take the other side of the trade. Some brokers will offer both options, so it is your choice as to which one suits you.

It will not be easy to find out which model the broker uses, as sometimes they use hybrid models or complicated algorithms. The best way is to ask them directly, look at the minimum account requirements, see if they offer price depth, and know what type of commission model they have.

An online broker serves as an intermediary between you and the market exchanges in return for a commission.

Electronic Communication Broker (ECN) / Non Dealing Desk

Electronic Communication Brokers offer direct market access by using automated systems that match buy and sell orders with other market participants. They match your trade with a counterpart that can be anyone from retail investors to banks, to brokers and other financial institutions.

It is important to understand that trading directly with the exchange and skipping the online broker is practically impossible as a retail investor. It requires a large amount of capital, and the individual trading needs to be a regulated broker-dealer who is connected to the clearing firm. As this is rarely the case with most people who want to trade, the broker is the intermediary who places orders in the exchange.

ECN Brokers offer direct market access, and they do this by using automated systems that match buy and sell orders with other market participants.

There are two types of direct market access: True DMA and One-Touch DMA. The main difference is that there is no last look—no human intervention—with True DMA. When you place a trade using True DMA, the broker’s computer places your trade automatically to the exchange. When a broker uses One-Touch DMA, an actual person has to click a button for your trade to get placed on the exchange.

As you have probably worked out, when using One-Touch DMA, your trade can incur a loss of speed when trying to open or close a trade with your broker. So, why doesn’t every trader use True DMA, you may be asking? Some countries do not allow the use of True DMA—they make it obligatory that a human checks the trade before placing it on the exchange (due to fraud or not enough funds to cover the position, for example).

There are two types of direct market access: True DMA and One-Touch DMA. There is no human intervention when a trade is placed on the exchange through True DMA. There is with One-Touch DMA.

These type of brokers usually offer a win/win business model. If the trader is consistently profiting from the financial markets, he will trade regularly. This is beneficial for the broker, as he receives the trader’s commission per transaction.

So how does it work?

Client places sell trade on broker platform

Client places buy trade on broker platform

Broker sends the order to the exchange

Broker sends the order to the exchange

Trade is placed on exchange

 

Let’s take an example of a local market place:

  1. You want to buy a boat directly from the boat manufacturer, but only employees can buy boats from the manufacturer.
  2. You happen to know someone who works there. He agrees to buy a boat for you but with the condition that you pay him a fee for his services.
  3. You agree, and he buys the boat for you for $200,000. You pay him a $6,000 fee.
  4. After a few months, the boat suddenly goes up in price.
  5. As a smart entrepreneur, you think you can make a profit by selling your boat at a higher price.
  6. You call your friend again, and he says that he knows someone who will buy your boat. You agree on a fee for him again.
  7. The friend sells your boat for $270,000, and you pay him a $6,000 fee.

In the analogy above, you can see that the employee in the boat-manufacturing company can be seen as a broker, and the fee can be seen as the broker’s commission.

Pros

o Lower transaction costs due to no human intervention.

o Lower spreads, because the spreads vary and brokers do not touch the spreads. This allows you to trade the spread. (The spread is the difference between the sell price and the buy price.)

o Quicker executions on trades, as they don’t have to go through an intermediary.

o Less chance of human errors and issues.

o Most brokers offer anonymity. This assists bigger traders, as no one can see their strategies, and others cannot anticipate their trades and take the opposing side.

o Price depth is usually available (level 2 prices).

o Transparent broker commissions. When you are trading DMA, the broker will usually charge you a separate commission. This increases transparency.

Cons

o There is no fixed spread, and it is more difficult to calculate an exact exit, as the spread varies.

o Less margin is generally available.

o Bigger trading account is needed.

o Limited financial products are available.

o Education is not usually offered by these types of brokers.


Market Makers / Dealing Desk

Market makers are liquidity providers who will always ensure that they offer a buy price and a sell price. Market Makers will display their own quotes, and they are legally obliged to show the best possible price. Their goal is to make a profit from the spread. This is also known as a quote-driven market in which you are shown a price, and you decide whether to accept it or not.

The quotes that Market Makers show are correlated to the exchange quotes, but they may differ in regards to the actual market prices, as the Market Makers show their own prices.

Market Makers are liquidity providers who will always ensure that they offer a buy price and a sell price. Prices may vary slightly from real-life market prices.

Market Makers can be brokers, but they can also be banks and financial institutions. Most Market Makers will take the opposite side of your trade (trade against you), assuming the risk on their order books (account). They do this by buying or selling from their own inventory, thus creating a Market. Market Makers are essential in the market, as they create liquidity and stable prices, and they are always readily available for buying and selling financial instruments.

Most Market Makers will take the opposite side of your trade (trade against you), assuming the risk on their order books (account).

Let’s see an example:

  1. You go to the market place with the intention of selling 20 tomatoes for $10.
  2. There are currently no buyers, but the market-stand owner decides to buy all of your tomatoes, as he knows that he will soon be able to resell them again.
  3. As the stand owner assumes the risk and offers to buy them for $9, you agree to the sale.
  4. A few buyers come into the market, and the stand owner decides to sell the tomatoes for $11.

As you can see in the above example, the stand owner has served the purpose of an intermediary for buying and selling the product. He has gained his commission in the transaction by adding $1 for each transaction that he did. The stand owner is essentially creating a market willing to buy the tomatoes for $9 and sell them for $11.

Pros

o Fixed spreads. It is easier to determine entry and exit points.

o In-built commission. The commission is already included when you see a price quote. Many traders prefer this commission model.

o Market Makers offer a wide variety of financial instruments.

o There is a wide selection of brokers available.

o These types of brokers usually offer a wide variety of education.

o High margin accounts available.

o No re-quotes.

o Lower trading-account requirements.

Cons

o No price depth offered.

o Poor transparency.

o Prices may vary from the underlining market.

o Most Market Makers make money when their clients lose money.


Straight Through Processing Broker / Non-Dealing Desk

This type of broker (STP) is a hybrid model of a Market Maker and an ECN Broker. STPs sometimes pass your trade to liquidity providers to place your order in the exchange, and other times they will not, acting as your counterparty.

The main difference between an STP broker and an ECN broker is that STPs use liquidity providers such as banks as your counterparty, and they do not match your trades with other market participants.

This type of broker is a hybrid model of a Market Maker and an ECN Broker. The main difference is the model that STPs use for matching trades with other market participants.

Most STP brokers’ commission models are inbuilt in the spread, meaning they generate their revenue through the spread that is added to the price that they obtain from the liquidity providers. They sometimes offer a fixed spread or variable spread, and they offer anonymous trading.


Bottom Line

Different broker models offer different advantages and disadvantages. In summary, Market Makers are most frequently used by beginner traders, and ECNs and STPs are mainly used by advanced traders. This is because Market Makers tend to offer extensive education and available financial instruments, and they require smaller trading accounts to get started. Market Makers may be a good way to get to know the market and to take your first plunge into the markets.

ECN and STP brokers are mainly for an experienced trader. They don’t tend to offer educational services, and they require accounts with a minimum deposit ranging from $1,000 to $10,000.


 

ECN

STP

Market Maker

Dealing Desk:

No

No

Yes

Trade execution:

High

High

Mid-High

Min. Initial account deposit:

$10,000

$1000 – $10,000

No min. deposit required

Source of revenue:

Separate Commission

Spread, sometimes trades against clients

Spread, sometimes trades against clients

Goes to exchange:

Yes

Sometimes

No

Type of spread:

Variable

Fixed or Variable

Normally fixed

Offers market depth:

Yes

Sometimes

No

Offers trader anonymity:

Yes

Yes

No

Offers education:

No

Rarely

Yes


Summary

P

An online broker serves as an intermediary between you and the market exchanges in return for a commission.


P

ECN Brokers offer direct market access, and they do this by using automated systems that match buy and sell orders with other market participants.


P

There are two types of direct market access: True DMA and One-Touch DMA. There is no human intervention when a trade is placed on the exchange through True DMA. There is with One-Touch DMA.


P

Market Makers are liquidity providers who will always ensure that they offer a buy price and a sell price. Prices may slightly vary from real-life market prices.


P

Most Market Makers will take the opposite side of your trade (trade against you), assuming the risk on their order books (account).


P

The Straight Through Processing Broker is a hybrid model of a Market Maker and an ECN Broker. The main difference is the model that STPs use for matching trades with other market participants.

 

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