What Every Forex Trader Should Know About ECNs vs. Deal Desks

Many forex traders are concerned about going to an ECN broker and not trading through a deal desk. In this article I hope to shed some light about how this works and what to look for when selecting a broker to make sure that you don't become a victim of un-just dealing practices.

An ECN dealing model allows the many market participants to execute trades with each other through an electronic network. That's what an ECN stands for; electronic communications network. As you know, forex is a zero sum game so for every winner there is a loser; for everyone going long there is someone going short. So what an ECN does is match up your order with the order of another market participant. You are probably asking yourself the same question as I asked myself when I first found out about an ECN, will there be a seller every time I am buying and vice versa? The answer is that there are market makers and banks in the ECN that are consistently taking on trades and hedging their risk. They may have their own buy and sell programs that they are trading on. These banks allow clients to get better liquidity and tighter pricing in the ECN. One of the most profound benefits of using an ECN is that you get anonymity, as the other participants do not see who is trading on the other end and cannot flag your account and trade directly against you. Another benefit to consider is that you can make your own market in an ECN; meaning you can place orders in between the bid and the ask price. If you are not willing to trade at a particular price point, you are able to place a bid or offer in between the spread in hopes of the ECN finding a fit counterparty – this is not a possibility with a deal desk.

Some forex dealing firms use a dealing desk approach. With this approach their desk acts as a sole market maker and takes all long and short positions on. The desk has certain risk parameters that have been set up and based on these calculations the aggregate net position of the dealing desk is hedged. So, if the desk itself is net long or short a certain amount of EUR/USD for example, they will take a trade of that amount in the opposite direction with a liquidity provider. If all the clients are net long 1 billion EUR/USD, the desk will go long 1 billion EUR/USD and thus have a hedged position. So for every pip they loose in aggregate to their clients they will win on their hedge. Its obviously not as simple as I just explained it but that's the basic nature of the dealing model. Some of the advantages of going through a deal desk are that you always know your transaction costs as the spreads stay fixed, you know who the counterparty will be every time in case you need to get issues resolved. There are however some disadvantages as well, the dealer will always know who you are, and you can not go in between the bid and the ask.

Although many people are strong proponents of the ECN model which does seem a lot more transparent, the dealing desk approach can work just as well, as long as you are trading at a well capitalized firm with numerous deep liquidity relationships. The bottom line is you want to make sure that everything about your dealing firm, platform and over all trading set up is a fit to your needs. However there are some things you need to check right away to make sure that you are trading at a solid firm, because what good are tight spreads if you cannot withdraw your money at the end of the year? It's always a good idea to research your forex broker before you decide which route you'd like to go.

In general first find out the firms capitalization. You can find this at http://www.cftc.gov/marketreports/financialdataforfcms/index.htm. You want to make sure that the firm is well capitalized, I would say over $25 million for adjusted net cap is a good start. This means that they have enough money to have solid liquidity relationships. Next I would actually ask the firm who their liquidity providers are. You want to make sure they are big firms like JP Morgan or Bank of America. Some firms may claim they have no dealing desk on their websites, but in actuality send all their order flow to another dealing desk, you need to be really careful about that. In this case you would be much better of using an IB as you can lower your transaction costs by receiving a volume rebate and trading at the source. One way to check this quickly is an ECN will always have floating spreads. Spreads can not be fixed at an ECN. So if somebody is offering fixed spreads and saying they have no dealing desk. Guess what? They are going to another dealing desk.

Happy Trading,

Alexander Nekritin

Alexander Nekritin is a professional trader with over 8 years of experience. His specialties include risk management and system development. Alexander is the CEO of NCMFX, Inc., which is a forex introducing broker and an educational company that helps suit client's needs in forex trading. He offers a Forex broker review to his clients that assists in finding an appropriate clearing firm. Alexander has a degree with a concentration in Investment Banking and derivative instruments from Babson College in Massachusetts. Click here to go to TradersChoiceFx.