Forex brokers are in this business for one sole purpose; to make money. Many forex traders may not be aware however revenue model of a forex broker directly affects the success of clients’ trades and investment. Therefore understanding how forex brokers make money will help traders to see the difference between genuine honest forex brokers and forex scams.
A big majority of forex brokers use these two business model in order to make money; Straight Through Processing and Market Making. I am going to use those business models to give you a clearer idea on how forex brokers earn money.
First, I like to talk about how Market Maker brokers earn money from the services that they provide. It is not complicated to understand because Market Maker forex brokers profit when their clients lose money. Contrarily, this type of forex brokers loses money when the clients profit from their trades.
Therefore, in a way, Market Makers trade against their clients and it is considered as an unethical way to make money. At the same time, that is the most profitable way as well. I would recommend you to avoid brokers that profit when traders lose. If the forex broker is offering very low spreads, and charging no commission, then, the broker is most likely a Market Maker and trading against the clients to earn money.
STP Forex Brokers
The biggest source of profit for the forex brokers comes from spread, which is simply the difference between Bid and Ask prices. STP brokers match client orders directly with LPs (Liquidity Providers) and their profit is originated from the extra mark-up that they add on to the raw spreads received from the LPs. For example, let’s say a forex broker charges 0.8 pips spread on EURUSD. In order to be able to earn money, the broker must get lower spread from the liquidity provider, such as 0.5 pips. In this scenario, the forex broker earns 0.3 pips on every EURUSD trade that clients execute. Since the pip value of 1 lot EURUSD is $10, the broker is going to earn $3 from every 1 lot EURUSD traded.
Forex brokers charge or pay overnight swap fees to the clients depending on the difference between the interest rates of the currencies traded. For example, let’s say that you are long EURUSD and EUR overnight interest rate is higher than USD overnight interest rate. In this case, you are going to be paid the rate differential between EUR and USD. On the other hand, if you are short EURUSD, then the broker would charge you by the difference between EUR and USD interest rates. But swap fees are not symmetrical, which means that the swap fee that you are going to get charged if you are short may not be equal to the swap fee if you are long. Besides, in some cases, you may see that the brokers charge swap fees regardless of the direction of the trade that you take.
Just like traders can make bigger profit with higher leverage, forex brokers make more money when the leverage is higher. This is because what brokers can earn from the spreads on small positions would naturally be too low. Thus many forex brokers offer high leverage to maximize their earnings. When there is leverage low, traders’ position size gets smaller and the brokers’ profit resulted from spread goes down as well. Once the leverage is higher, traders are able to execute larger size orders and spread cost gets bigger so, does the brokers’ earnings.
Just like the clients trade forex market in order to make profit, some forex brokers trade for themselves to increase their revenue, which is usually called as proprietary trading (Prop Trading). They do so by trading a much higher lot in the same direction with their profitable clients and in the opposite direction with the unsuccessful traders.
ECN Forex Brokers
There is also another category of forex brokers that I would like to mention; ECN forex brokers. This type of brokers provide direct access to interbank exchange rates and matches their clients’ orders with interbank rates. Therefore, the clients can trade with raw spreads coming from the biggest banks in the world such as Deutsche Bank, Citibank, Barclays, etc. ECN brokers charge commission on each trade executed by the clients and it is their only source of income. The commission rate usually ranges from $4 to $8 per standard lot on EURUSD.