The foreign exchange market is an over-the-counter market where anyone can exchange one currency for another. Most people will have participated in this market at some stage in their life.
The forex market is by far the biggest market in the world. It trades around 2 trillion dollars a day. It would take the New York Stock Exchange about 3 months to trade the same volume of money as the forex market does in 1 day.
From that alone, it can be seen that there is a deep pool of money to be tapped into everyday.

An “over-the-counter market” means that there is no central clearing exchange in the forex market, like in the NYSE, where buy and sell orders are matched.
Instead the banks and institutions are all linked around the clock by internet, fax and telephone creating one market of sorts.

Trading in the forex market has gained amazing popularity over the last few years with retails clients. There are literally dozens of retails brokers who offer anyone the chance to open an account in their bedroom. It’s possible to open an account with sums as low as 100 dollars now. These brokers provide state of the art software platforms that enable you to trade many currencies. The websites are usually glossy affairs, advertising “commission free” trading.
Because the forex market is an OTC market, it means that it is basically unregulated. The disadvantage of trading with these retails brokers is that market integrity is brought into question, due to the lack of regulations.

How is the market integrity brought into question?

There are quite a few things that the retails investor should know about the forex market before trading it.
The best way to look at the retails forex market is by looking at the website of a retail broker and look at each claim one by one.



However before looking at each claim, I instantly notice one of the most important assurances is missing from their claims list…

Everyone wants to know how safe will their funds be that they deposit. In the past most retail brokers claimed that customer funds were placed in a separate account from the firms account. The phrase used was “customer segregated account” However the legal landscape in an OTC market is doesn’t recognise the difference between customer and company assets. This means that of the firm files or bankruptcy then the customer funds will become creditor funds also. This means there is the very real threat of losing all your deposited funds in the case of insolvency. However a recent mandate released by the National Futures Association (NFA) states that all Forex companies must disclose that customer funds are not protected:

“The transactions you are entering into with [Member] are not traded on an exchange. Therefore, under the U.S. Bankruptcy Code, your funds may not receive the same protections as funds used to margin or guarantee exchange-traded futures and options contracts, which receive a priority in bankruptcy. Since that same priority has not been given to funds used for off-exchange forex trading, if [Member] becomes insolvent and you have a claim for amounts deposited or profits earned on transactions with [Member], your claim may not receive a priority. Without a priority, you are a general creditor and your claim will be paid, along with the claims of other general creditors, from any monies still available after priority claims are paid. Even customer funds that [Member] keeps separate from its own operating funds may not be safe from the claims of other general and priority creditors.”

I don’t notice this warning anywhere on this broker’s homepage. Instead I found it half way down the small print of the risk disclosure which had to be opened from a small faint link at the bottom of the homepage:

10. There is no Central Market or Clearinghouse Guarantee of Payment.

Forex trading with us is not conducted on a regulated market or exchange. Each Contract is a contract directly between us and the Customer. There is no clearinghouse and no guarantee by any other party of our payment obligations to the Customer. Customer must look only to us for performance on all Contracts in Customer’s account and for return of any margin or collateral. Our insolvency or a default by us could cause Customer to lose the value of its account and to suffer additional losses from open positions.

Now on to the claims made by this broker…

1. Fixed Spreads.

The first claim that this broker makes is they have fixed spreads. To start with the spreads are much wider than you would expect to get, if you were using a broker on a central exchange, like the CME or CBOT.
The other problem with the claim of fixed spreads is that it’s very rarely true. Let’s take an example; the spread on the EURO/USD is usually 2 or 3 pips. However on the most actively traded times of the day this spread has been known to widen to as much as 10 to 20 pips. What does that actually mean in context…?
It means that if your account is in USD, and you are trading 1 lot, then you are paying 100 USD commission if the spread widens to 10 pips, i.e., 10 USD per pip value*10=100 USD. That commission free trading claim is starting to look rather expensive.

2. Free Advanced Trading Tools

Well as these retail brokers want to attract the novice, beginners and people with insufficient capital who want to chance their arm in the FX market they obviously have to offer free charting. If they were to offer professional charting packages like ESignal, Tradestation, Ninjatrader etc etc then this would provide a barrier to the beginner. The reason being that in some cases the subscription fee to some of these software packages costs the same per month , as it would to open an account with a retail FX broker.

3. Dozens of currency pairs and metals

Nothing intrinsically wrong with this claim. It just means they offer lots of currency pairs, including cross rates. The spread can be as wide as 15 pips on the cross rate currency pairs before slippage or spread widening.

4. Daily exclusive institutional market analysis.

The keyword here is “exclusive” It’s the keyword because all retails brokers offer exclusive market analysis. It’s no big deal.

5. 24 hour trading and support

I m sure they do offer 24 hour support; any company should if they are trading in a 24 hour market.

6. Trade immediately with credit card, Paypal, Webmoney etc etc

This sounds a little precarious to say the least. It is possible for you to instantly deposit money on credit and trade a highly risky financial instrument, with leverage of up to 200:1. You can trade a position the equivalent size or larger than 100,000 USD with 1% margin with money using a credit card. The similarities between this claim and a casino are striking. Its obvious the retail forex brokers are targeting people with a disposition to gamble. The funny thing is that in the small print in the risk disclosure, I paraphrase that it states that FX market is highly speculative and therefore risky, and people should only speculate with money they can afford to lose. People depositing money with credit cards to speculate on highly leveraged financial instruments can obviously not afford to lose money.

7. Start trading with $200 and leverage of 200:1.

I have grouped claims 7 and 8 together. I think the contrast and conflict between these 2 statements shouldn’t go unnoticed. This is saying that you can open an account with $200, and then control positions within your account with 200 times bigger than your margin. To me this is pure gambling. The point is that with the leverage available in the forex market, it would be financial suicide to try and control large positions with a small bank size. As said before the retail brokers use high power marketing techniques that sell the dream to the novice that anyone can make money in this business. The advertising of high leverage, is akin to casinos offering big payouts “if” you hit the jackpot.


8. NO commission or fees

This claim of no commission or fees is one of the most appealing aspects to the newbie or novice trader. It sounds like a fantastic deal on the face of it. When you understand how the FX market works and the dynamics of placing a trade, it becomes apparent that the no commission claim is more than made up by the spread used between the buy and sell price. The best way to demonstrate this is by comparing a trade made using a broker who uses a central exchange (CME) and a retail broker operating in the OTC market with fewer regulations.

First of all we will take a look at placing a trade through a regulated central clearing exchange….


DOM
This is a DOM,(above) which means Depth of market screen. Retail brokers never provide one of these for their clients. When using a broker that operates in a transparent market, traders will likely use a DOM to place trades.
This DOM is showing a GBP/USD future contract on the CME.

The price ladder shows all the prices where the market has been trading at recently and where it may trade.

The black arrow in the middle of the price ladder indicates the current price you can buy or sell this contract.

If you click the left side (Green) where the BIDS are placed at 194.45, you will buy this contract at 194.45.

Conversely if you click on the right side(red) where the ASK prices are displayed at 194.45, you will sell this contract at this price.
Note this example assumed that no slippage took place.

Lets assume I placed a trade to BUY this contract at 194.45, and I closed it out again at 194.60. This is called a round turn. It just means that I opened and closed a trade, ie, a round-turn. Most futures brokers that work through a central exchange charge a fee for doing a round-turn trade. That means they charge you for opening and closing a trade. This is how they make their profits.
They just provide a platform for buyer and sellers to meet (central exchange) and exchange commodities, currencies etc. They are not a market maker. There software platform matches buyers and sellers. So if there is enough people buying and selling at the price you want (liquidity) then you can trade at the market price.

Now what is the cost of placing a trade like in this example?

The cost of placing this trade (opening and closing) with a future broker, depending on which broker you use, would cost anything between 3 and 7 USD.


Now let’s look at placing a similar trade with a retail forex broker…