Though market making was the first brokerage model adopted in the retail FX market, it is no longer the most popular amongst many established brokers or amongst those starting out, this is primarily due to the increased costs, capital requirements and risks associated with running a regulated Retail FX Brokerage.
Initially Brokers began with very little regulation as the Retail FX industry boomed, there were requirements in place but a lack of education and knowledge in a new industry resulted in many Brokers being able to get away with some very shady behaviour, however this did not last as regulators began to catch up and to enforce stricter rules on each of the regulated Brokers. This increased regulation and an increased education amongst traders also resulted in a greater level of transparency within the industry.
As the growth of FX propelled brokers onto our TV screens, the number of investors looking to setup brokerages grew as many saw the opportunity to make good returns, but not all could afford to be market makers as capital adequacy controls were being enforced thereby restricting the B-Book exposure which a Broker could take on, also an even greater risk to these Brokers was the possibility of a number of successful traders being able to put a brokerage with insufficient capital into financial difficulty. With these restrictions and dangers in mind, Brokers needed an approach with less risk that could still ensure a profitable business, with that the STP model was born.
STP or straight through processing refers to trades which are passed directly to a liquidity provider and are executed through pre-trade execution, thus mitigating the risk to the broker. Pre-trade execution operates through the following method, once a trader executes a trade, the broker receives a price from their LP for a client trade before giving that price plus mark-up, to the client. For this to work, traders must trade using market execution and through this, Brokers earn revenue solely through mark-ups or commissions they charge without bearing any risk of losing money against their clients or on poor trade execution. Therefore it is in the Brokers best interest that a client continues to trade and that their account lifespan extends for as long a time as possible.
As the broker is not trading directly against the trader many prefer the STP model as there is no direct conflict between the broker and client, however as we have alluded to before, there is always a counterparty to your trades and it is the larger LPs who are often responsible for widened spreads and sharp market moves that cause Slippage which traders so often blame a retail broker. Though there is a LP on the other side of your trade, a key benefit to trading through STP is Anonymity. All trades/orders will remain with your broker until they are triggered, unlike with Market Makers, your counterparty cannot see your pending orders or your Limit/Stop levels, and this allows clients to trade without fear of stop hunting or market manipulation. Though clients can trade with anonymity, unless you are trading very large volumes you can be sure that the market will not pay much attention to your trades as their size is merely insignificant.
The STP model is ideal for brokers looking to start out and it’s a very a suitable model for those traders willing to trade market execution. The pitfalls of Slippage and VWAP do exist but many will take these over the stigma of trading against a Market making broker.
STP – For not conflicted, anonymous Traders! Do not let LPs know it was You!
#tradesafely #NoConflict #BeAnonymous