The big FX myth. Do Market Makers trade against me?
When you trade on a market maker's rate they are taking the risk into their own book. The purpose being to facilitate client's business and offer the best possible spreads - see our blog on why dealing direct with the market maker is the best option for trading FX - but some of our broker competitors have propagated the idea that market makers 'trade against you'. The suggestion is obviously that you should trade with them. The difficulty there is that, if they are acting exclusively as a broker and taking no risk, they need to pass the risk directly on to someone who will i.e. a market maker and they need to take a brokerage or markup. So the risk generally ends up with a market maker anyway AND with an additional layer of cost.
But the idea is out there, so let's have a close look at it. First lets look at why market makers take risk on to their books. A market maker publishes a continuous two way rate, allowing clients to trade at the time of their choosing. Assume a market maker has a number of clients. Client one sells to the market maker, thinking the market goes down. The market maker could at this point turn around and sell to the market, as a broker would. But then he cannot profitably show the market rate - buying from his client at the market rate and then selling at the same rate doesn't create a sustainable business, one that can continue to add value to its clients.
If the market maker takes client one's trade into his book, there is now a window in which another client may show up and buy on the other side of the spread. That is why market makers take risk into their books - it is to open a window in which buyers and sellers can match off across time, allowing the market maker to capture spread as compensation for providing their service, and show a better rate than brokers. It isn't to trade 'against' their clients.
Let's look a little more closely at the period between clients one and two trading. If there is anything that gives the 'trading against' nostrum its superficial appeal, it is this period where the market maker is long and the client is short. Surely this is zero sum? If the market goes up the market maker wins and the client loses, and vice versa. Surely the market maker is trading against client one? Well, not really. The market maker temporarily has an opposing position from facilitating client ones ability to trade on the best rate. But he is not married to it. He would like to see another client show up or a passive hedging order fill as soon as possible after client one trades to neutralise his risk. And so we come to the issue of horizon.
Differing horizons - or holding periods - is what makes the relationship between market makers and their clients work, and gives the lie to the idea of trading against clients. Different parties can win to a trade, so long as they have different holding periods. Lets say the market maker is publishing a rate of 20/21 when client one sold. So the client is short and the market maker long at 20. The market maker is then paid three minutes later at 21 on a passive order. Another three minutes passes and the market falls to 17/18. Client one buys back his short, earning two pips. The market maker earned his spread and the client was right about the market's direction and locked in his profit.
So the market maker and client can in fact have a symbiotic relationship, and the market maker can facilitate the clients ability to express his trading ideas without the layers of costs of any of the alternatives.