How do Forex Brokers make money?
Let’s face it. It will be more profitable to run a Forex broker than trading in the market. Why? The return on investment can be comparably higher than the profits made from trading. In our previous post we have introduced the two main business models of brokers; Straight Through Processing and Market Making. Now, we will use those business models in order to provide you with a clearer idea of the profits brokers make.
First and quickly, we will touch on how Market Maker brokers profit from offering their services. Well, this is simple they profit when clients lose money and lose when clients profit. Overall, due to the law of averages, human emotion, a high percentage of inexperienced traders and other factors the overall majority of traders lose money. So, provided a Market Maker has a good pool of clients they will always profit from the losses of clients, and those losses will typically always exceed any profits other clients make. This is a very simple concept to understand but what is not so simple are the ways an STP broker makes money as it is often not so clear and requires some explaining. For that reason we have addressed six ways an STP brokers can profit, as follows.
Let’s assume that we have a pure STP broker that covers all its clients’ orders directly with LPs (Liquidity Providers). In this case the profit for the broker comes from the mark up that they have added on to the “raw” spreads they receive from their LPs. To understand this better let’s use an example. If a broker offers a spread of 0.8 pips on EURUSD then they must have a deal with their liquidity provider for a lower spread for example of say 0.2 pips. In this example if a trader open and closes 1 lot of EURUSD then irrespective of any profit or loss they make the broker will make a fixed 0.6 pips profit. If the pip value of 1 lot EURUSD is $10 then the broker will profit $6 ($10 pip value * 0.6 pips). You should also be aware that brokers often pay some commissions on volume but for this example we will keep it simple.
Is that the only way STP Forex brokers make money from clients’ trades? No, it’s not so let’s dig deeper a bit more to see how the brokers can produce more profits for themselves.
In our previous example we mentioned spreads on the EURUSD. But what will happen if your position remains open during the night. Your account will probably get charged with a swap fee or you could receive a swap fee back depending if the direction of your trade is in your favour. If you look a bit closer and look at the swap fees you will notice that there is a spread between the swap fee paid and the swap fee charged depending if your position is long or short. In some cases brokers charge swaps in both directions, which doesn’t reflect true market conditions. If you question your broker they are likely to tell you that they pass on the swap rates they receive from their LPs, which may or may not be true.
Another thing to notice is that in order to trade with a broker you obviously need to deposit to and withdraw from your trading account. Some brokers might cover the transaction fees but some others will not. If you have used a lot of Forex brokers then it highly likely you came across a deposit or withdrawal fee one day and you were wondering why the hell you received less money than you sent. If you contact your broker it is likely they will tell you that the amount was charged from an intermediary bank (when you have used a bank transfer) or the PSP (Payment Service Provider). Some brokers cover these costs, while others pass them on, sometimes for a profit. Also, it common for brokers to establish special agreements with their Banks and their PSPs so they can receive a small percentage back from the transaction cost, which you could call a rebate. A profit on every single transaction going through a typical sized broker can add up to quite a tidy revenue stream.
Another way for STP brokers to profit is to trade for themselves, which for a Forex broker is often referred to as “Proprietary trading”. In the event that you are a very successful trader and you are working with a true STP broker then they can simply follow your trading strategy and trade a higher volume with their LP. If for example you trade 1 lot, which profited $100 the broker can easily place 3 lots for the same position and make you $100 as well as $200 for themselves. Similarly, STP brokers can trade by doing the opposite of unsuccessful traders and also reap profits.
Profit sharing liquidity deals
It is clear to most traders that a broker using the Market Maker model profits directly when clients lose but it is also possible for STP brokers to have secured a profit sharing agreement with a LP, which is a market maker. So, ultimately depending on the liquidity deals in place it is possible for an STP broker to still profit, indirectly, when their clients lose money.
Infrastructure Licensing and White Label Agreements
Another point worth mentioning is that many Forex brokers have developed their own internal IT systems such as a CRM (customer relationship management system), back office, payment processing, reporting or any other systems that are required to better facilitate the operation of a brokerage. Therefore, brokers often license these parts of these systems out to third parties under licensing deals, allowing new brokers to enter the market without huge upfront development costs, under a recurring license fee. Some brokers even have their own trading platforms or resell the platforms of third parties under white label deals.
To sum up, Forex brokers have many revenue streams even if they are using a pure STP broker model. Got any comments please let us know we would love to answer your questions.