There is a saying amongst market professionals that applies equally well to stock brokers, forex brokers, futures brokers: “your broker will only make you broker”. To understand where this saying comes from, all you have to do is watch the first 15 minutes of “The Wolf of Wall Street” or “Bolier Room”, “Wall Street” or even “The Pursuit of Happiness”. These movies are all depict the same type of scenario: the broker gets a phone book or some other sort of list and calls away, trying to generate business for the firm.
The clients are psyched by the sales pitches they receive and decide to adhere to the broker’s recommendations. They enter into transactions (embracing market risk) while the firm rakes in the commissions (risk-free). Times change, technology changes…but some things remain the same. Just like in the past, even today brokers are execution partners, not investment advisors. Brokers want you to trade, and they offer user-friendly interfaces and great support.
So while some form of broker is necessary, in order to interact with the market, we should understand what we can legitimately ask of a broker and what we should not ask of our broker. In this article we shall try to create a framework for choosing the right one for our personal needs.
Brokers can be organizations (Charles Schwab, Merrill Lynch, E*TRADE, etc.) and individuals, and make their money through various fees, including the following:
- Brokerage commissions: This is a fee for buying and/or selling stocks and other securities.
- Margin interest charges: This is interest charged to investors for borrowing against their brokerage account for investment purposes.
- Service charges: These are charges for performing administrative tasks and other functions.
Any broker you deal with should be regulated by an investment authority (for example, FINRA & SEC in the USA or FSA in the UK) and have some sort of client money protection scheme (for example the SIPC in the USA). Check out http://www.sec.gov/investor/brokers.htm for some more information.
Not all countries regulate the same way, nor do they have the same regulatory environment and requirements when it comes to financial registration. Do you feel more secure operating with a broker in Cyprus or with a broker in the UK or USA? Which country hosts a regulatory body that will more likely act in the interest of the investor? We must always keep in mind that regulation is important when things go sour. You want to be able to hold your broker responsible for any non-ethical practices or wrong doings, and have assistance from the regulatory body.
Countries with dedicated regulatory agencies include:
- USA (FINRA, SEC, NFA)
- UK (FCA)
- Eurozone (MIFID plus national agencies like the CONSOB in Italy)
- Japan (FSA, JIPF, FFA, JSDA)
- Australia (ASIC)
- Switzerland (FINMA, POLYREG)
What are some “shady” practices that should alert you that you are dealing with a broker that is not strictly regulated?
- Your broker downplays the importance of the disclosure statement and/or execution risks
- Your broker openly suggests that you to borrow money to invest
- Your broker guarantees you can be successful and/or you can make X% return on your capital in a certain amount of time
- Your broker promises profits because they give you advice using something that sounds logical like “market cycles” or “seasonal factors”
- Your broker solicits action based on the impact of current news events
- Your broker leads you into believing you can profit from already public information.
And it’s a good practice to check the registration of the broker, to validate it’s legitimacy. The NFA has a search engine for broker/dealers operational in the USA: http://www.nfa.futures.org/basicnet/
Are you looking to invest/trade stocks, bonds, currencies, futures, etfs…or maybe all of these? Know which markets you want to trade, and then go and do your due diligence on the brokers that fit your criteria. Just remember that not all markets have the same regulatory requirements. For example, spot forex is traded OTC (over the counter) so it’s very important to understand the execution facilities, conflicts of interest, client money and main regulatory body for the broker of choice. This is totally opposite the situation you would have if you were interested in trading futures: all futures products are exchange based, so it’s much more difficult to incur into shady practices. However, this does not exempt the investor from doing due diligence.
Understanding the nature of the execution model your broker uses is especially important in FX, as there are currently a few different types of companies to work with.
Pure Brokers (NDDs): loyal to it’s original figure, a broker acts as a conduit between the client and a market maker/dealer. This is performed by processing orders with computer systems instead of manual (human) intervention through a dealing desk (hence the label “Non Dealing Desk” on these brokers). The technology the broker uses in order to send client orders to a market maker, is called Straight Through Processing (STP). The spreads that the client receives are dependent on the market maker that the broker routes the client’s orders through, and the broker’s own markup. Brokers generally charge fees for this service and are also compensated (sometimes) by the market maker for the transactions that they route to it. The No-Dealing-Desk model can potentially limit conflicts of interest because the broker only receives commissions and is not interested in the outcome of the client’s trade. Also, the NDD has little to no market exposure, which can help avoid insolvencies.
Dealing Desks/Market Maker Model: each market maker has a “dealing desk,” which is the traditional method that most banks and financial institutions use. Market makers provide two-way pricing to clients throughout the day. The easiest way to pinpoint a market maker model is to watch the spreads: if they quote fixed spreads, they are almost certainly a market maker (because spreads in the real market fluctuate all the time, all day, based on liquidity). Banks, investment banks, broker/dealers, and FCMs make up the majority of this category. Market makers are compensated by their ability to manage their global FX risk. This may include spread revenue, netting revenue, and revenue on swaps (the overnight roll) and conversions of residual profits or losses. The market maker model generates significant conflicts of interest: since the client is essentially trading onto the market maker’s book, then it’s not clear whether the market maker is totally
Pure ECN: the concept in FX is very similar to a pure brokerage model, except for the fact that the ECN acts as a broker to multiple market makers or counterparties. Each counterparty sends a price to the ECN as well as a particular amount of volume that a quote is “good” for, and then the ECN distributes that price to the client. The ECN is not responsible for execution, only the transmission of the order to the dealing desk from which the price was taken. In this system, spreads are determined by the difference between the best bid and the best offer at a particular point in time on the ECN. In this model, the ECN is compensated by fees charged to the client plus a rebate from the dealing desk based on the amount of volume that it is given from the ECN. You can recognize a pure ECN as they usually show the volume available for trading each bid and offer. However, this volume is only relative to that particular ECN and is not a reflection of the entire market.
Once you know how your order is being treated, you can scan the broker’s GUI (Graphic User Interface – the actual trading platform) and test hos intuitive and robust it is.
Basically there are two solutions: desktop download or web based software. A dektop download can be more stable, while the web based platform can be lighter on the CPU. Also, many brokers now offer android/mobile apps, so that you can trade with a reasonable degree of comfort from just about any device. One of the main concerns is the stability of the program: does it freeze often? Does it require a really sturdy internet connection to work well? During news events does it tend to slow down? These may seem like evident questions, but the fact is that too often newcomers get lured into using a certain broker, only because their platform “looks good” and is “easy to use”. It’s true that placing an order or closing a trade should be simple operations to do, but they are not the only (nor the most important) aspect of a GUI. And what about the charts? Is the charting package complete? Can you trade from the charts or must you input everything? These are questions that depend more on your trading style, but just make sure your broker suits your trading style and has a reliable platform.
Much more important that the GUI is the capitalization of your broker. We have touched on this point earlier but now we’re going more in-depth. There is a quick way to see the capitalization and the positioning your broker has, compared to it’s peers. The CFTC keeps an updated report:
Better capitalization usually means that there’s a sturdy management, good underlying business model, more credit relationships with liquidity providers, more competitive pricing, possibility to invest in technology and/or meet new industry requirements with little fuss. Here is what the CFTC spreadsheet looks like:
The OTC nature of the market makes extremely difficult for a broker to get competitive pricing without a margin deposited in a lending institution or bank – thus the importance of having a well-capitalized broker as your counterparty, because they will probably not need to put their hands into your pockets in order to meet certain requirements. It is extremely important for individual investors to do extensive due diligence on the Forex broker with which they choose to trade, reading carefully the client agreement. Look at this:
Section of a client agreement
In the case above, the broker can freely access client’s funds for hedging it’s own exposure against it’s counterparties, putting client’s money at risk. How relaxed do you feel? Also, remember to look for contact information in case you need to voice your concerns about serious behaviour. Look at the following:
Detail of a client agreement: there is a clear email to send complaints to. This is a positive.
Also, watch closely to see if your broker is acting as principal (they are your direct counterparty) or agent (they are passing your orders onto the market). Conflicts of interest are limited if your broker is only an agent. As for Client Money, your funds should be in segregated accounts – so that in case your broker incurrs into default or has to face legal charges that are not directly linked to your trading behaviour, they cannot use your funds for anything.
Customer Support and Complaint Resolution
One of the most imporant things you should check in a broker is the support service. Everything goes fine during normal times…but what if you get an abnormal price, abnormal slippage…or you feel that the execution is delayed or you have issues with your GUI and can’t close a trade that is immensly profitable? You should be able to voice your concerns at almost any time, in your native language. Does your broker have 24/5 support in your language? Which medium is used to contact the help desk: email, chat, or can you speak by phone to a live person? Do the representatives seem knowledgeable?
When you probe your broker, while trying out their demo and facilities, make sure you ask them some tough questions (regarding regulation, execution, client funds, what happens if you have a trade going and cannot access your account, etc) and see how they respond. You will be able to get a feel for their dedication and legitimacy right off the bat. Compare their answers to the client agreement and see if they were not telling you the whole truth. Basically, try to find out how your broker will act when something goes wrong. Some of the better brokers also have a clearly defined escalation process that clients can use when submitting a problem. And maybe it’s the case to keep your broker’s phone number close to your computer, so you can call them asap if something goes wrong!
Finally, we get to the nitty gritty part. And it’s not a mistake that the cost structure is here at the end of the article. The main reason for putting the cost structure here is that you should not allow a low spread (on FX) or low commissions (on futures/equities) to lure you into trading with a certain broker. Too often, low costs mean low quality. The better brokers require you to pay for ther services.
This is extremely true in the FX spot market, where market makers promise no exchange fees or regulatory fees, no data fees and, best of all, no commissions, in order to get your business. So in Forex trading, be careful when you see very low spreads, especially when they are fixed. On the other hand, it’s perfectly reasonable to have slightly higher – yet variable – spreads. What you also want to look out for is WYSIWYG policy: What You See Is What You Get. This should mean that there is no hidden slippage, no requotes…your order is either executed or it isn’t (yes, it can happen). No hidden fees.
Regarding hidden fees, also watch out for the rollover component. You may be trading intraday, so this would not apply. But if you hold positions overnight, you want to knw exactly how much you will be paying/making on interest rate differentials. It’s just another component of your trading fees, so why not know it in advance?
Want to know how much the spread can impact your trading? Go to http://fxtrade.oanda.com/lang/it/analysis/spread-cost-calculator/ as Oanda has structured a calculator that takes into account your trading habits and will show you just how much difference a few pips can make.
For Futures & Equities, the situation is a little different. Typical costs to be aware of are:
Maintenance Fee : a fixed fee for maintaining your account – which you pay whether you trade or not. Discount brokers normally do not charge any maintenance fees.
Commission Per Share: some brokers set the commission for a trade according to the amount of shares that are involved in the trade. Such brokers are most convenient for investors and traders that trade stocks in smaller volumes (as a rule, less than 1000 shares per trade). Interactive Brokers or Lightspeed set their commissions in this fashion.
Commission Per Trade: some brokers offer the same fee for one trade regardless the amount of shares involved in the trade (so called flat fee). This kind of commission structure is offered for example by Sogotrade, E*Trade or Scottrade. These brokers are suitable for traders (or investors) who trade in larger volumes (more than 1000 shares per trade).
Inactivity Fee: with some brokers you have to be aware of the fact that if you do not make a minimum amount of trades for a certain period, you will automatically be charged an inactivity fee for example at Interactive Brokers or TradeStation. The inactivity fee also applies to some Spot FX brokers.
Minimum Deposit: another thing to consider is that most brokers require you to make a certain minimum deposit in order to open an account. This is usually several thousand dollars, and this is a big difference relative to Spot FX brokers, which allow you to open accounts with 50 USD. The reason behind this big difference is in the type of execution and instruments traded. When trading on a regulated exchange, and trading standardized contracts in futures or commodities, you typically need more margin in your account. So basically, the choice of the broker also depends on how much capital you have, and what instruments you wish to trade.
Over to You
The choice of a broker is not easy. You need to know what instruments to trade and how often you will trade them. After deciding this, you can go through a due diligence check on various competitors, finding out how “respectable” they are and if there are any major proceedings against them. Find out if they keep your money separate from the firm’s capital (segregation). Finally, find out what their costs are and what type of interface they use.
It’s a little bit of work, but if you’re committed to being a profitable trader, would you really risk operating with a firm that may keep you from profiting, or that will not give you your well deserved profits?
Be sure to check out our Guide for further guidance on how to select the right broker for your needs.
About the Author
Justin is a Forex trader and Coach. He is co-owner of www.fxrenew.com, a provider of Forex signals from ex-bank and hedge fund traders (get a free trial), or get FREE access to the Advanced Forex Course for Smart Traders. If you like his writing you can subscribe to the newsletter for free.
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