Banks, non-banking financial organizations, and retail traders are the three main participants in the foreign exchange market. Retail traders might need more financial resources to engage directly in the interbank currency market. Electronic communication networks and market makers allow retail traders to trade currencies.
So let us explore these market makers’ identities and how they contribute to the forex market.
The Market Makers and Their Role
A market maker is someone who consistently buys and sells currencies on the OTC market at a price that is publicly published. By doing this, a market maker serves as the opposing party in most trades executed by retail traders. In short, the market maker sells when a retail trader buys a currency and vice versa. It should be noted that a market maker always trades against the herd. Liquidity provision for any traded asset is one of a market maker’s primary responsibilities.
A market maker is paid by adding a markup to the bid and ask price in exchange for completing this role. The profit a market maker makes from his function as the spread represents a liquidity provider the difference between the ask and bid prices. A market maker bases the price they offer only on supply and demand.
A market maker does not want to manipulate the market by building up positions to forecast the direction of price movement. They only facilitate an immediate transaction at the advertised price, eliminating the necessity to wait for a counterparty. A market maker makes sure that price movement is smooth by doing this.
The Pros and Cons of Market Making
Market makers may benefit smaller-scale and private investors.
The following are a few pros:
Pros
- Investor Confidence: Market makers play a vital role in instilling confidence in investors. Their presence reassures investors that the assets they are considering are worthwhile investments. Market makers have extensive knowledge and expertise in analyzing assets, which allows them to provide valuable insights and recommendations. As a result, their actions and strategies act as a gauge for the overall market sentiment.
- Safety and Accessibility: Market makers serve as custodians, ensuring the safety and accessibility of assets. They facilitate the buying and selling of securities, making it easier for investors to enter or exit positions. Without market makers, smaller-scale and private investors may have limited access to certain assets or face challenges in executing their trades.
- Seamless Markets: Market makers contribute to the functionality of the market by adding volume and liquidity. They continuously provide bid and ask prices, narrowing the spreads between the buying and selling prices. This liquidity ensures that there are always buyers and sellers in the market, allowing for efficient and seamless transactions. It also reduces the impact of large buy or sell orders on the asset prices, promoting a stable and orderly market.
Cons
Market makers have several advantages, but it is important to note that they also have certain disadvantages:
- Competing Interests: Market makers often operate as both brokers and dealers, which can create a conflict of interest. As brokers, they are obligated to provide customers with the best execution possible. However, as dealers, they act as counterparties and engage in profitable trading. This duality can lead to situations where market makers prioritize their own trading interests over the best interests of their customers. Investors need to be cautious and aware of this potential conflict.
- Insider Trading: Market makers have access to a wealth of market information and trading data. While they are bound by regulations and ethical standards, there is always a risk that some market makers could exploit non-public information for personal gain. Engaging in insider trading can lead to severe regulatory actions and harm innocent investors who do not have access to such privileged information.
- Influence on Market Integrity: Due to their significant involvement in trading a wide range of assets, market makers can influence market prices. Their actions and trading strategies can create ripple effects and influence investor behavior, leading to herding behavior and potential market distortions. This can harm market integrity and impact investment decisions. It is crucial for regulators to monitor and regulate market-making activities to ensure fair and transparent markets.
Market Maker vs. ECN/STP Brokers
When it comes to trading in the financial markets, including the foreign exchange (Forex) market, traders have a choice between market makers and Electronic Communication Network (ECN)/Straight Through Processing (STP) brokers. Understanding the differences between these two types of brokers is essential for traders to make informed decisions. Here’s a comparison between market makers and ECN/STP brokers:
Definition and Function
Market Makers: Market makers are entities that provide liquidity by quoting bid and ask prices for a wide range of financial instruments, including currency pairs in the Forex market. They act as counterparties to traders’ trades, buying and selling at their quoted prices.
ECN/STP Brokers: ECN/STP brokers, on the other hand, connect traders directly to the interbank market or liquidity providers. They do not take the opposite side of traders’ positions but instead pass the orders to the market, offering direct market access.
Execution Model
Market Makers: Market makers often operate on a dealing desk model, where they execute trades internally, matching buyers with sellers. They may offer fixed spreads and instant trade execution.
ECN/STP Brokers: ECN/STP brokers operate on a no-dealing desk model, where they route traders’ orders to liquidity providers or the interbank market. This allows for transparent pricing and potentially tighter spreads, but trade execution may not be as instant as with market makers.
Spread and Pricing
Market Makers: Market makers typically offer fixed spreads, which means the difference between the bid and ask prices remains constant regardless of market volatility. This provides certainty to traders but may result in wider spreads during periods of high volatility.
ECN/STP Brokers: ECN/STP brokers offer variable spreads, which means the spread can fluctuate depending on market conditions. During normal market conditions, the spreads tend to be tighter, but they can widen significantly during news events or periods of low liquidity.
The Bottom Line
In summary, market makers are crucial to the FX market. They offer liquidity and price stability by purchasing and selling currencies at publicly available rates. Retail traders can now engage in the foreign exchange market without needing significant funds to invest directly in the interbank currency market.
However, it is crucial to know which forex broker is a market maker before hiring them. A market maker has considerable disadvantages, such as conflicts of interest and insider trading. Investors considering using a market maker for their trading activity should know these hazards.
