Market Makers, STD and ECN Analysis

Is market making a form of gambling?

In the Chinese foreign exchange market, most investors believe that market makers are akin to gambling, effectively betting against clients' positions. Many forex firms attract clients by promoting “STP or ECN” trading models during their market expansion efforts.

So, what is the operating model of a market maker?

First, it's important to understand the concept of a market maker. A company with market-making qualifications represents a certain level of qualification and credibility in the market, indicating a high-quality, large, and strongly capitalized company. Being a market maker means being under strict regulation (such as ASIC regulated full-license brokers with trading account qualifications, i.e., market-making qualifications), having sufficient capital to provide liquidity, and possessing adequate technology to offer transparent pricing, thereby providing fair services to clients. This is the essence of a market maker.

Moreover, it plays another role, which is maintaining market price stability, something that a strong market maker can achieve. Thus, a true market maker has a positive image.

However, many people in China have a negative perception of market makers, equating them to gambling platforms. Gambling platforms do not transfer their own risk; they keep all clients' orders in hand and stand against the clients. When positions are severely imbalanced, gambling platforms often manipulate the backend to achieve profits.

Brokers with market-making qualifications have the strength to take on clients' positions, not with the intention of affecting the clients' positions. Clients' trading and the brokers' management of the risks generated from clients' trading positions are independent matters.

Market makers have the capability to scientifically and reasonably transfer their own risks; for example, if a client buys a Euro/US Dollar position, the broker sells the same position. Market fluctuations affect both the client and the broker after a position is passively created. The broker observes the market and incurs losses if the market rises. If the broker agrees with the client's direction, thinking that the euro will rise, the broker will hedge this risk in the market. The broker's hedging direction aligns with the client's, not against it. In this scenario, the broker can transfer risk without affecting the client's trade. Additionally, when brokers enter the market, their order sizes are large and not hedged individually for each retail client due to high costs and unnecessary complexity. Brokers manage a portfolio of risk positions stemming from clients' trades, incorporating various products to create diverse position combinations. By exploiting the interconnectedness of commodities, currencies, and indices, brokers manage and adjust their risk position portfolios. Their significant market entries are designed to hedge risks in a way that is imperceptible to the market, avoiding price spikes, which is a broker's duty.

During significant market movements, retail traders become highly active, while broker transactions tend to decrease, as it's unnecessary for brokers to react to every client's move. Brokers have their own judgment and risk control systems, enabling them to scientifically and judiciously manage their own risks. Trades are client-driven, and the platform operates independently, separated by a clear "firewall".

Only in cases of large-volume trades must orders be handled directly by the platform, as it's impractical for investors to execute trades worth billions at their desired prices instantly. In such cases, the platform communicates with clients about the lack of market liquidity for their orders, helping them find liquidity and determine execution prices through various banks, which takes time. While professional clients understand this process, Chinese clients might not, expecting immediate execution at seen prices. However, market prices can change rapidly, and there's a time lapse between order placement and execution. Currently, there's no technology capable of solving this issue at the retail level without significant cost.

Most brokers in the market are retail foreign exchange CFD brokers, with a few offering institutional services. Claims of operating on STP/ECN models that supposedly route every customer order directly to the interbank market are exaggerations, as such transactions require clearing, which is too costly for high-frequency, small-volume orders. Thus, STP or ECN models are merely methods of order processing and price quoting, not actual routing of client orders to the interbank market.

STP ensures quick order processing due to strong liquidity providers in the background, like large brokers who automate order execution. Smaller institutions can't negotiate similar agreements with banks due to high margin requirements, opting instead to partner with larger brokers like those offering more favorable conditions and higher leverage. Thus, many small and medium-sized brokers prefer this arrangement.

Such partnerships form an STP ecosystem where client orders are processed efficiently, although not all transactions are handled via STP, with most choosing not to use it.

ECN is merely a pricing model, not an assurance of access to the interbank market. Only orders of immense volume that transcend retail trading are actually routed to the interbank market. ECN pricing benefits clients seeking lower spreads, but it also incurs commissions that inevitably pass onto clients as brokers bear significant costs in providing ECN quotes.

While it's fine for brokers to promote ECN/STP, claiming that all orders are routed to interbank markets, such as UBS or Goldman Sachs, is misleading and unrealistic.