Adopting a particular business model is important for brokers as it is a major criteria for traders to select their brokers. Also depending on your business model how you execute your client’s trades and charge commissions/spreads varies.
Brokers in the Forex market predominantly use two business models namely A book and B book models. While the A book model is favoured by ECN/STP brokers making it the standard for No Dealing Desk brokerage firms, the B book model is used by Market Maker brokers in the Dealing Desk brokerage firms. Some brokerages also use a mix of the two systems commonly known as the hybrid model.
Let’s find out more about the two main Forex business models.
A Book model – Brokers on the same side as traders
A Forex broker who adopts A book for his business model acts as an intermediary between the trader and the market. He executes his client’s orders by passing it on to liquidity providers, multilateral trading facilities or prime brokers. These Forex brokers make their revenue from charging commissions on the volume of trades or by charging spreads. Spread is the difference between the bid price and ask price of a currency pair.
Spreads are usually a few pips the broker adds to the trader’s buying price before placing his trade in the market. These spreads are a small fraction of the trader’s profit that the trader doesn’t mind sharing with the broker for his services. This model is mostly used by ECN (Electronic Communications Network) brokers and STP (Straight Through Processing) brokers. ECN/STP brokers function by providing a platform for the trader to find the counterparty for the trade.
For instance, if a trader wants to buy Euro the ECN/STP brokers match the trade with another trader who wants to sell Euro in the interbank market and links it with a liquidity provider. So there is no conflict of interest as the broker acts as a mere intermediary and makes a profit irrespective of his clients gain or loss.
This business model is becoming more and more popular among Forex brokers as traders prefer brokers working in their best interest instead of against them. In this business model the brokers are on the same team as the traders as the interests of the broker are aligned with that of the trader encouraging the trader to give a profitable environment for his traders. The brokers also benefit immensely as more profitable traders means more trading volume and thereby more profits.
However one disadvantage with the A book model is that as trades are passed through to the interbank directly, in some cases it may not be possible to execute the trade instantly at the order price. In this scenario, the order will be executed at the closest possible price and this difference between the order and execution price is known as slippage. Slippage can be both positive and negative and will be split between the trader and broker.
B Book model – Brokers taking the opposite side
The B book business model is primarily used by Market Maker type of brokers. These brokers acts as the counterparty to their clients’ trades as they execute the trade by the taking the opposing position of the trade. Small brokerages follow this model as these brokerages find it difficult to match up buyers and sellers in the interbank with their limited volume of trade. If brokers are to wait till they find the buyer or seller for a client’s trade it may take longer to process the order.
So, in order to process the trade immediately the broker himself takes the opposite position of the trade. For example, if a client predicts USD is going to gain in value and wants to buy the currency, the broker may not be able to find a trader selling USD, so he becomes the counterparty and sells USD to execute his client’s trade.
But the problem with this model is that if the currency gains as the client expects, the broker stands to lose as he is selling the now more valuable currency. On the other hand, every time a trader makes a losing trade the broker makes a profit. This may create a conflict of interest as the interests of the broker and the trader are not aligned.
Adopting the B books usually turns out to be very profitable for brokers as majority of retail traders lose money on their trades. If a client’s order is on the correct side of the market and the broker deems it to be too risky for him, brokers may even reject such orders. Also these brokerage firms have certain risk management strategies like internal hedging through matching of opposite orders of clients, spread variations, etc., in place to manage significant losses.
The Hybrid model’s increasing popularity owes it to the profitability and credibility that comes with this model. Brokers use a mix of both A book and B book systems in this model. Under this model, brokers identify profitable and unprofitable traders through software that analyses their clients’ orders. The software analyses trades using filters like deposit size, leverage used and risk factors.
Profitable traders are identified and passed on to prime brokers/liquidity providers on which brokers charge commissions/spreads. Unprofitable traders are counter traded by the brokers and the client’s losses are the broker’s profits. These profits made from the B books allows a broker to provide all clients with competitive spreads.
Which side are you on?
The available business models in the Forex market provide brokers the options of being on the same side of the clients or the opposite side. While one adds credibility to your brokerage, the other brings a lot of profitability. In days to come, whichever of these models that provides traders with an advantageous trading environment will gain dominance. So, which side are you on?