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About ECN Brokers
Before you can understand how ECN brokers operate, first you need to learn how a typical broker, be it stockbrokers or currency brokers, run their businesses.
Traditionally, brokers acted as matchmakers. If you had anything to sell, you go to a broker and offer them what you want to sell and tell them at what price you would sell the item. The broker then tries to find a buyer for you who is willing to match your price. When you want to buy something, the process is reversed. Basically, a broker acts as a database of willing buyers and sellers. The broker matched buyers and sellers, the volume or quantity of the assets or commodities, and earned a commission by providing this financial matchmaking service.
Before the rise of computer networks, you would usually call your broker on the phone and conduct your business. It was a cumbersome and time-consuming process as things were done manually. However, a company called Instinet first introduced an electronic method of conducting the brokerage business in 1969, which they called Electronic Communication Networks (ECN). The digital system of ECN limited the role of the broker and matched the best bids and offers automatically. Hence, immensely improving the speed of order processing and execution.
There were some other fringe benefits of using an ECN broker compared to a dealing desk or manual brokers. Since bid and ask prices got into the database or “book” of the broker and there was no human intervention, traders could be assured that there was no price manipulation. Or, the broker will not try to create an internal market by buying or selling themselves. This eliminated any potential conflict of interest. The seamless trading operation meant traders could place orders outside of market hours. Consequently, the ECN brokerage model became popular in almost all industries, including the global interbank market.
The Benefits of Using an ECN Forex Broker
Currently, most reputed Forex brokers try to eliminate the dealing desk and offer the ECN model of conducting business. However, while ECN brokers are great for efficiency, they do have some pitfalls that beginner Forex traders should be aware of. Before we discuss those, let’s take a look at some of the benefits of using an ECN Forex broker.
Direct Market Access
Traders conducting business with an ECN broker get direct access to the interbank market. The middleman, the broker, does not control the price feed or meddle in the process of matching buy and sell orders. Hence, all orders flow directly from the retail investor to the liquidity provider.
Spreads are the markups Forex brokers charge as fees to traders. Since ECN brokers do not control the bid and offer prices, they cannot control the spreads as well. The spreads fluctuate depending on a range of factors such as supply and demand of the currency pairs, and volatility at a given time.
The benefit of variable spreads is that it makes markets more efficient. When spreads are wide, most short-term traders would avoid trading, but long-term traders may still buy or sell as their profit targets are large enough to justify such large spreads. Hence, variable spreads suit the need for scalpers who need tight spreads to make a quick profit as well as long-term traders who are not that sensitive to price and need their orders filled fast.
ECN Brokers are Not the Counterpart of Any Trades
Dealing Desk Brokers, who use digital platforms to be the counterpart to their client’s trades try to buy at a lower price and sell at a higher price to its clients. This model of brokerage business creates a direct conflict of interest between the trader and the broker.
However, ECN brokers pass the clients’ orders directly to the third-party liquidity providers and earn fees from transaction costs known as commissions. As all ECN brokers do not run any dealing desk, they eliminate the conflict of interest and traders can rest assured that their brokers are operating as a neutral entity.
Orders Get Filled with ECN Brokers Without Requotes
With dealing desk brokers and their fixed spreads, if the price of a currency pair moves too fast, the trader is hit with a requote. Because filling the order at the price as intended by the trader will likely generate a loss for the broker.
ECN brokers will match your buy or sell orders with other sellers and buyers regardless how fast the price moved after you have placed the market order, or when your limit order is triggered. If there were not enough liquidity at a given price point, the ECN broker will fill your order partially and you may have to deal with slippage. But you can be rest assured that there will be no annoying requotes.
ECN Brokers Ensures Anonymity
ECN brokers send their client orders into a pool of liquidity providers by aggregating all orders in one direction. Hence, if you place an order to buy five mini lots worth of EURUSD and the brokers get another five mini lots of orders of other clients, they will bundle it to send one standard lot of buy orders at the given price to the interbank market.
The aggregation of the orders protects individual traders from any bias against any particular strategy. As a result, ECN brokers do not care if you are a scalper or you are a long-term trader. All orders are treated equally.
While a lot of dealing desk brokers will not allow scalping, ECN brokers hardly care if you are opening and closing 50 orders in a minute!
The Disadvantages of Using an ECN Forex Broker
While trading with an ECN broker provides traders with certain benefits, small retail traders might find some of these “fair” policies detrimental.
Variable Spreads Makes It Difficult to Assess Reward to Risk Ratios
Most retail Forex traders use fixed stop losses and have a certain expected reward from each trade. If you have a 20 pips profit target and want to risk 5 pips, then suddenly find that the spread has gone up from 2 pips to 10 pips, your reward to risk ratio would deteriorate instantly.
Small retail traders often find it difficult to deal with variable spreads and sometimes, it is better that orders do not get filled at unfavorable conditions than getting filled at any cost.
High Initial Deposit Requirements
Dealing desk brokers are famous for accepting new clients with as low as $50 initial deposit. In fact, a lot of brokers may not even have a minimum deposit requirement. However, the same broker offering true ECN facility may require that you deposit thousands of dollars for the privilege of opening an ECN account.
Most retail traders find these high initial deposit requirements a burden, and it may pay to start trading live with dealing desk brokers in the beginning.
Commissions Can Add Up Quickly
ECN brokers may offer low spreads during highly liquid market conditions, but they will surely charge you a hefty commission. While these commissions are not that large compared to the position size, if you are day trading, it can add up to a sizable amount.
Also, counting commissions make it difficult to keep track of actual profits. You cannot simply count how many pips you made in a day; you have to dig through the account statement to find the actual cost of trading.
How to Identify If Your Broker is Really an ECN Broker or Not
There are few shady Forex brokers that try to masquerade as ECN brokers, but in reality, they may be just another dealing desk broker. The good news is you can easily spot a real ECN broker. Just lookout for the following things:
ECN Brokers are Often Regulated in Reputed Countries
Since ECN brokers have an honest business model, most of these brokers voluntarily get brokerage licenses with reputed regulatory authorities. However, keep in mind that some ECN brokers deliberately do not get regulated by the U.S. regulators to avoid strict rules. You may also find ECN brokers doing business from rather obscure jurisdictions because they want to accept U.S. clients without adhering to FATCA rules.
Low and Variable Spreads
Almost all – actually all – ECN brokers offer variable spreads. During important news releases, these spreads become lower, instead of going up because of the increased liquidity.
Ability to Place Orders Between Bid and Ask Prices
While dealing desk brokers will not be able to fill in an order that falls in between the Bid and Ask prices, you can do so with a true ECN broker.
Full Access to Level II Data
ECN brokers offer Level II order book data on their platform. Not just a handful of them, almost all the pending orders on the books should be visible along with volume information.
Scalpers are Welcome
If your ECN broker tells you that you cannot deploy a scalping strategy, it may not be a true ECN provider. ECN brokers will never distinguish traders based on what strategy they use.
ECN brokers are transparent and have no conflict of interest with their clients. However, the high deposit requirement along with variable spreads and commissions makes ECN model brokers more suitable for professional traders. Nonetheless, we have researched and reviewed some reputed ECN brokers that are suitable for both smaller retail and more experienced traders alike.