Why dealing direct with the Market Maker is the best option for Forex Trading
We need to declare our bias here. We have been making markets in FX in investment banks since 1994. Initially in Options and then since 2004 in spot FX, when we were part of the team that built BARX (Barclays Capital's e-fx business). We are convinced it is the best model for facilitating client business. Clients in the institutional space clearly agreed with us. There was significant concentration of market share in the hands of the main e-FX enabled banks, all of whom were running a market making model.
So what exactly does an e-fx market maker do? They continuously form and publish a two way price, standing ready to buy or sell at the time of a clients choosing. They then take that risk onto their book in order to try and link buyers and sellers across time.
There are two alternatives to dealing directly with a market maker - going through a broker or an ECN, an Electronic Communication Network.
Lets say you have just set up a broker or an ECN. What is one of the first things you need to get your business going? Prices. You need someone to make you a continuous stream of prices. Who do you turn to? Who is in the business of continuously forming and publishing rates that your clients can trade on? Market makers. So you set up a relationship with a market maker who streams you prices. You stream them to your clients. When your clients trade, you immediately pass the trade through to the market maker, since you are not in the business of taking risk.
Suddenly you notice the flaw in the business model. Your clients sell to you at the market makers rate and then you sell to the market maker at that rate. You don't make any money. You can't keep the coffee machine full of beans or the beer fridge full. You realise you need to either charge commission or add a spread to the market makers rate. Hmmmm, ok, so now clients business is going to end up with a market maker AND with an additional cost to the client of the brokerage or markup. Damn. So there is no way you can be lowest cost supplier. And that is why we think dealing direct with the market maker is the way to go. It gives traders the most effective, cheapest market access ensuring more of their profits stay with them.
Some brokers, knowing they can't be the cheapest solution for your trading, have gone to work propagating Fear, Uncertainty and Doubt to the effect that market makers trade 'against' you. Others, and the ECN's, will try and say they bring together the prices of multiple market makers, giving you a better rate. That's a whole blog in itself..