Jul 26, 2013

There is a lot of debate going on about market makers and ECN brokers. This article will discuss what an ECN broker is all about, as well as its advantages and disadvantages.

Knowing what an ECN is and how it is different from a market maker can be helpful in choosing a broker. It is important to know how these different kinds of brokers operate in order to figure out which would be best for your forex trading career.

What does ECN mean?

ECN stands for Electronic Communications Network. It refers to a computer system that facilitates forex trading outside of exchanges. They are also sometimes called Alternative Trading Systems or Alternative Trading Networks.

ECN brokers collate prices from various market participants on its network, such as banks, retail traders, and financial institutions. It displays the bid/ask prices from these market participants on its trading platform through the FIX (Financial Information Exchange) Protocol technology.

Market Makers vs. ECN

Unlike most market makers that offer fixed spreads, ECNs usually have variable spreads. This is because price-setting by ECNs depends on the behavior of the pair and the pricing of other market participants in the network.

Market makers usually take the opposite side of a client’s transaction while ECNs match orders with those of its other clients. They set the bid and ask prices by themselves and publish these on their trading platform. Market makers make money by taking the opposite side of a client’s trade and through a fixed bid/ask spread while ECNs charge a fixed commission cost per transaction.

With that, market makers present a conflict of interest that is not present when trading with ECN brokers. Pricing offered by ECNs reflect market conditions while market makers’ prices are often given to their advantage.

In addition, a larger risk of slippage is present for market makers, as they can widen the bid/ask spread during volatile trading sessions. They can even decide to freeze trading or make a particular currency pair unavailable to prevent traders from opening or closing positions with the pair. Pending orders might not get filled at the prices specified by the trader.

The similarity between the two though is that both market makers and ECN have retail and institutional arms. Retail market makers and ECNs are involved with transactions of retail traders while institutional market makers and ECNs comprise banks, large financial institutions and hedge funds.

Pros of ECN brokers

The main advantage of trading with an ECN broker is that you have access to better prices since these are based on those given by other traders and institutions. Although slippage can still take place during volatile trading environments, pricing by ECNs is usually considered as fair because it is generally determined by supply and demand.

In addition, ECN brokers are not trading against you since they simply match the orders with other clients. There is no conflict of interest between the broker and the client. As such, prices reflect real market conditions and the broker has no incentive to adjust bid/ask prices to their advantage. Forex ECN trading is completely anonymous, enabling traders to deal with neutral prices.

Prices on ECN platforms tend to be sensitive to volatility, which makes trading with ECN brokers ideal for scalping. Liquidity also tends to be better among ECN brokers, guaranteeing faster trade execution. During periods of high activity and liquidity, spreads on ECN brokers can be very narrow as the broker can easily match a client’s order to another.

Fixed commissions costs are charged by ECNs versus market makers that profit by varying the spreads. With that, transparency is better among ECN brokers because the transactions costs are already fully disclosed before the trade is executed. This is not the case for market makers which can manipulate the bid/ask spread in order to get higher profits.

Also, unlike market makers that can decide against executing a trade, ECNs are not trading against you as they are simply matching your orders with others taking the opposite side of the trade. As a result, they are not likely to manipulate prices or prevent you from executing your trade at your desired price.

Cons of ECN brokers

There is a fixed commission fee for every transaction since this is how ECN brokers make money. Still, this is usually cheaper and more transparent compared to the costs incurred with larger bid/ask spreads or unfair prices given by market makers.

Calculations of stops and targets may be challenging to do on ECN broker platforms as price keeps moving and because of the variable spreads. Slippage is still a possibility, especially during session overlaps, as various factors and clients are affecting price ticks all at the same time.

Choosing a Broker

At the end of the day, having a clear idea of which characteristics you prefer will be crucial in helping you decide what kind of broker you should open an account with. If you prefer fixed commission fees and tighter spreads, you might want to consider trading with an ECN broker. If you would rather have your broker take the opposite side of your trade, then go with a market maker.

Liquidity and trade execution are important factors to bear in mind when choosing a broker. It is ideal to open an account with a broker that can guarantee seamless and instantaneous order execution at a fair price.

Opening a demo account with an ECN and a market maker can help you decide which kind of broker you should trade with. First-hand experience of knowing how a particular broker operates and executes trades can give you a clearer idea of what will be better for your trade performance.

Before opening a live account with your broker of choice, make sure you go through the fine print and read the terms and conditions for managing a forex trading account. There are some details that vary from broker to broker and even among ECN brokers or market makers, so it’s necessary for you to know the important details.