Should you consider using a Forex ECN platform?

>>> RETAIL e-fx CLIENT Should you consider using a Forex ECN platform? the middle of the bridge, says Layth Sanjaq, head of operations at FXCBS. On one side, there are the banks quoting prices into the client terminals through the broker s platform. On the other side, there are the traders (clients) performing trades on those streamed prices. Each trade goes through the broker s platform to the corresponding bank that quoted the price and gets executed using the liquidity provided by the bank. To find out if you really are trading on an ECN, says Ross Ditlove, CEO of MB Trading, there is a very simple test that can be employed. Ditlove explains: Find any currency pair on any broker s system. For simplicity, use a pair with a three or more pip spread. Let s say the Bid is 100 and the Offer is 103. Now enter an order to Buy at 101. If you and everyone else on your broker s system do not immediately see your new Bid at 101, thus making the market now 101 by 103, then you are not on a true ECN. It s that simple. Without displaying your order immediately or at all for everyone in the system to see and act on, your broker is somehow manipulating the quote behind the scenes, says Ditlove. MB Trading s revenue is generated from the commission we charge the retail client, and thus we offer full transparency without manipulating the spread or quote, he continues. Why DD and NDD? The reason some brokers now offer both dealing desk (DD) and non-dealing desk (NDD) FX trading facilities, says Giuseppe Zagara, managing partner and the co-founder at Fastbrokers.com, because NDD I t is important to first define the term ECN. Traditionally ECN stands for Electronic Communications Network, a term that came from the (then) new electronic means of connecting to the NASDAQ market place. Since FX lacks both a central global exchange and market handling rules, brokers have begun to stretch the definition to ECN to suit their particular systems. Heather McLean Forex ECN platforms sound in theory like the ultimate utopian environment for trading. They can provide a place where orders are matched in real time in a collective bubble of liquidity provided by each of the market s participants. However, as Heather McLean discovers, there is more to the world of the ECN than meets the eye. 124 april 2010 e-forex What is an ECN? Vladimir Kisyov, head of business development at Deltastock, adds to the definition: The ECN basically provides a marketplace where individual and institutional traders, market makers (MM), prime brokers and banks trade against each other by placing competing bids and offers, thus generating liquidity into that electronic system. The ECN environment allows clients orders to interact with other clients orders. All trade orders are matched between counterparties in real time. The FX ECN model can be described as a two way bridge where the broker is the traffic coordinator in The FX ECN model can be described as a two way bridge where the broker is the traffic coordinator in the middle of the bridge april 2010 e-forex 125

RETAIL e-fx CLIENT >>> because it requires advanced requirements in terms of technology, an excellent IT infrastructure and can bear high development costs, he adds. Vladimir Kisyov The ECN environment allows clients orders to interact with other clients orders. All trade orders are matched between counterparties in real time. is the answer to the growing number of FX traders demanding more transparent and fair pricing. He comments: Retail Forex is today a mature product and traders understand its logistics (including the fact that pricing and trades are often handled in a market making environment). While there are still a few brokers using ambiguous statements about the nature of their retail forex system, most brokers are now offering a variety of trading environments to satisfy the growing demand of alternative products, often in place of the classic dealing desk. Changing expectations Today, we see a significant change in terms of clients expectations, Vedikhin points out. Clients from all backgrounds, including retail, are becoming increasingly demanding with regard to the suite of services they are being offered by their broker. All traders are now requesting institutional-level execution speeds, and NDD execution helps us to deliver on that. While approximately only 5% of retail clients trade via ECNs today, we expect this to grow to over 95% within the next few years. The benefits of ECN trading, including transparency, deep liquidity, market depth and NDD execution, will then become available to everyone. On brokers offering both DD and NDD FX trading facilities, Kisyov says the number of NDD FX trading facilities (either STP or ECN-STP brokers) has notably increased in the last couple of years or so. He comments: The shift from the DD to NDD business model has accurately addressed the growing needs of the forex trading community for greater liquidity and best execution, thus explaining the major migration of retail clients from MMs to ECN-STP brokers. Nonetheless, the DD model still provides advantages to traders. The logical consequence has been to see brokers offering an ECN-style environment. However, few brokers really allow their clients to trade these products, but simply made a major switch from the fixed spread model to a floating spread pricing which they marketed as a NDD or multi bank feed. Unfortunately these are merely DD-based systems which simulate or replicate the floating bid and ask of a true ECN model, but execute orders on a DD basis, states Zagara. Andrey Vedikhin, CEO of Alpari (UK), agrees that most brokers would like to be in a position to offer NDD execution because it allows for a much greater level of automation when matching trades. However, NDD execution is relatively difficult to achieve Giuseppe Zagara..most brokers are now offering a variety of trading environments to satisfy the growing demand of alternative products, often in place of the classic dealing desk. 126 april 2010 e-forex

RETAIL e-fx CLIENT >>> Sanjaq continues: I believe that brokers who are offering both DD and NDD are actually DD brokers trying to catch the trend by promoting NDD trading for their clients. The DD-NDD dilemma is ethical and can not be taken as a variety of services. Since an ECN broker s role is to give individual traders access to the interbank market, they do not benefit from the spreads or the losses of their clients. Therefore, they usually charge a commission fee per transaction proportional to the trade size. Besides, banks usually charge the ECN broker commission fees for transaction executed on their end. Wolf in sheep s clothing? While Ditlove comments: This is an example of a wolf in sheep s clothing. If your broker does not immediately display your bid or offer for all other clients to see, if your broker maintains minimum fixed spreads, if your broker knows information about your order that is not fully transparent to the rest of the marketplace and retail traders alike, then you re not getting a fair deal. Just because someone calls themselves a NDD-ECN does not make them so. Frankly, it s laughable. Yet the debate about dealing desks and non dealing desks (NDD) is a red herring, claims Glenn Stevens, CEO at GAIN Capital. He says as a retail trader, your Andrey Vedikhin While approximately only 5% of retail clients trade via ECNs today, we expect this to grow to over 95% within the next few years. primary concern should be your ability to get into a trade quickly and at the rate you request, and where your orders are filled. These things can positively or negatively impact your trading results; where your order is ultimately routed does not. Stevens explains: Our belief is that NDD s came about in response to complaints about the poor execution quality at some of the retail brokerages. Promoting themselves as a NDD was a way for brokers that entered the market late to differentiate themselves. It s fairly well known that when the first NDD firms came on the scene there were several firms with poor reputations for execution, especially where they filled their client s stop loss orders. Also, some brokers prefer the NDD model because it s much easier to take a price feed from a bank, mark it up to the retail customers, then push all the trades back to the bank, than to act as a MM and manage risk internally while providing the best client dealing experience possible. Continuing, Stevens states that GAIN Capital believes an experienced, professional trading desk is the real benefit to its retail clients at FOREX.com. We don t have an arm s length relationship with our clients; we take full responsibility for the prices we quote and where we fill orders. Conflict of interest In a pricing basis model, also known as a MM model, the prices are streamed from data vendors directly to the client terminals. Clients perform trades on the streamed prices, but the trades reach a dead end, which is the MM s servers. Meanwhile, the dealers of the MM are trying to negotiate execution for the favour of the MM and to minimise the profitability of their clients. Sanjaq states this model creates a huge conflict of interest between the broker and their clients, as the loss of the client is considered as pure profit for the broker. He states: As a client trading on MM s platform, when you are buying a currency pair, the MM is your counterparty (selling to you). Therefore, if your buying order goes in profit of $1000 for example, it means that the MM is losing $1000. It s as simple as that, unless the MM has a risk management policy that it applies to offset your order with a different counterparty at a certain point. Slippage and requotes are techniques used by MMs to minimise the profitability of the client. Scalping is usually not allowed by MMs because it gives the client higher 128 april 2010 e-forex

RETAIL e-fx CLIENT >>> a day; it s not feasible that we would or could trade against individual clients, Stevens concludes. Not robbers On possible conflicts of interest in order execution that can occur with MMs, Kisyov says: Market makers literally make the market for traders. They sell to buyers and buy from sellers by quoting fixed spreads. Unfortunately, most of the MMs quote variable spreads now. Market makers have been growing in number since the dawn of retail FX. I don t think they could have survived if they had robbed clients accounts, especially in this highly regulated environment, where clients interests have been strictly protected. Glenn Stevens..some brokers prefer the NDD model because it s much easier to take a price feed from a bank, mark it up to the retail customers, then push all the t rades back to the bank, than to act as a MM... chances of closing in profit few pips away from the opening price, which is inevitable loss for the MM. Vedikhin states that some FX brokers are criticised by retail investors for having a conflict of interest when executing client orders; they sometimes have to become the counterparty to their own clients trades. However, most of this criticism is unwarranted, he claims, because the majority of clients trade with brokers that are fully licensed and regulated by various agencies such as the FSA and NFA. Regulated firms like Alpari (UK) must abide by rules regarding best execution and treating the customer fairly at all times. This prevents any wrongdoing on behalf of the broker because regulated brokers are put under immense scrutiny by their respective regulator, he says. Stevens agrees: One of the biggest myths promoted by NDD brokers is that DDs are somehow trading against clients. This is hype. At GAIN, we re a hybrid model. We offset a potion of our trades immediately in the interbank market. Everything else is our net customer exposure and managed on an aggregate basis. We maintain strict position limits and hedge our exposure in the interbank market as needed, according to our risk management guidelines. In certain cases, we may offset customer trades immediately in the interbank market. We process well over 100,000 trades While Jesse Richards, a registered broker and a principal at Fastbrokers.com, comments: When the broker is on the other side of each trade, there is a conflict of interest as that broker will lose money if the client profits (if the broker does not hedge its risk), therefore the broker may be more profitable if the trader makes bad trades. I believe that the majority of deals done at NFA-regulated FDMs are done so on an ethical basis, however there are many unscrupulous brokers that actively manipulate the price to their advantage and to the disadvantage of the trader. The conflict of interest manifests itself in the execution of orders. The two most common forms of manipulation Layth Sanjaq Scalping is usually not allowed by MMs because it gives the client higher chances of closing in profit few pips away from the opening price, which is inevitable loss for the MM. 130 april 2010 e-forex

RETAIL e-fx CLIENT >>> traders complain about are stop hunting and spread widening. Richards adds stop hunting is the practice of a MM moving the price to hit a large number of protective stop orders, even if the price may not have reached that level through competitive pricing. In this scenario the MM pushes the price up or down by a few pips momentarily with the intent of stopping out traders and booking profits for the dealer. Spread widening is the practice of artificially widening the bid/ask spread when accounts are in a profit, to eliminate said profit or even forcing accounts to incur a loss due to margin issues, says Richards. Ditlove says MB Trading holds its liquidity providers to fairly specific terms that if they are showing a price, they have to execute a certain amount at that price. He adds that obviously, there are scenarios such as news releases where more orders are being fired at them and they also want to execute less. But compared to years ago when a deal desk could slip a customer 100 pips because of the non-farm payroll data releasing, things have come a long way, he claims, adding: Does every fill occur on the visible bid and ask at the time you click the button? Probably not under fast market conditions, which is no different then an NYSE specialist who is charged with maintaining an orderly market. That being said, the way to combat this circumstance is to add more liquidity venues to our system, Ditlove continues. MB Trading is an aggregator of liquidity; if we find that there is less then optimal liquidity we add more banks as sources. But that doesn t change the fact that our routing algorithms are very fast and our liquidity provider relationships are fairly deep, so the system will generally find a way to get a fill in a timely manner. The main point that I would focus on is that any slippage that occurs on our system is a function of global supply and demand, as opposed to a DD that refuses to give a retail client a fair deal in order to maximise their own profit. ECN settlement On how the FX ECN model works and how it operates on a settlement rather than pricing basis, Richards says because forex is a non-centralised market, there are two ways for retail traders to access it; either through a MM offering marked up liquidity from one or several liquidity providers, or through an ECN-style system. Jesse Richards The two most common forms of manipulation traders complain about are stop hunting and spread widening. Now, it should be noted that while banks, prime brokers and large institutional traders may operate on a settlement basis utilising a true ECN environment, most retail forex ECN style accounts still operate on a pricing basis even if they are STP, NDD accounts, Richards explains. On a retail forex ECN style system, while it may operate on a STP basis, the counterparty to the client s transaction is ultimately a prime broker, who is not aware of the identity of the client. Instead, the prime broker has a credit relationship only with the broker counterparty, that is, the company you would normally open an account and deposit your funds with. Retail ECN models eliminate the inherent conflict of interest that exists with a MM, but do not truly operate on a settlement basis. Costs and fees to trade on ECNs depend on different factors, according to Zagara. Generally speaking, he says the trader is offered an all inclusive commission quote which includes the broker s profit and fees. The broker then pays its fees to the prime broker and to the ECN itself, which charge a transaction or clearing fees, similarly to futures exchanges. Some of these charges do not apply to what Zagara considers to be home made ECNs. Also, he notes that while more brokers are embracing the forex ECN style, we can expect to see a growing commission battle among brokers, which will eventually benefit the traders; a similar path that the electronic futures have followed in the past. However, Kisyov adds it is the individual trading style that matters when choosing a trading model, in terms of the potential impact on trading performance. It is always about costs involved and execution when elaborating on the choice of a trading model. With variable spreads, the difference between the bid and ask prices of a certain currency pair fluctuates in a range. On the other hand, fixed spreads are predetermined under all market conditions. Kisyov states that Deltastock s fixed spread on EUR/USD is 2 pips, while it goes down to 0.1 pips in the ECN/STP module. The company has utilised direct pricing with no mark-up or mark-down from its liquidity providers, and the only fee that applies for ECN-STP order execution is 0.3 pips for trades as low as 10,000 base currency units. So, assuming a EUR/ USD order is executed at 0.1 pips spread, the bottom line for clients will be 0.4 pips total transaction costs. MT4 bridging issues Bringing ECN trading to the retail trader, many firms offering ECN trading now claim to bridge to the everpopular MT4 platforms. On issues with bridging an MT4 platform to an ECN, Ditlove says MB Trading spent more than a year finding out. He states: The short version is that MT4 is half a decade old at this point, and MetaQuotes is busy working on MT5 now. When MT4 came around, there were no ECN forex brokers. It s a round plug in a square hole. We had to meticulously consider every part of how MT4 s architecture worked and strip out pieces that simply didn t make sense in our current execution model. There are now a lot of brokers that claim to be FX ECNs with MT4, but we review what they are claiming and know that at best, they are simply routing orders out to one destination and again failing the transparency test. Most of the issues are technology related, although the prime reason for there being issues is because FX ECN s and MT4 have vastly different trading philosophies, says Vedikhin. The biggest challenge, he warns, is to be able to match client orders from MT4 with liquidity from an ECN. ECN s show market depth but MT4 does not, so it is important to resolve the issue of execution when an MT4 client wants a trade executed immediately at the best possible price. In MT4 it is not possible to provide partial fills, but ECN platforms often execute client orders at slightly different prices subject to available liquidity at a particular price. This core difference in approach can cause issues when bridging liquidity, he comments. Zagara says Fastbrokers.com explored MT4 bridging 132 april 2010 e-forex april 2010 e-forex 133

RETAIL e-fx CLIENT in late 2007, when more clients started to demand a real ECN execution delivered on the MT4. Fastbrokers.com concluded that clean bridging seemed to work only in theory. Zagara says: It is a very tough task to achieve in a live environment, mainly for the nature of the MT4 infrastructure, where its core, in my opinion, is mainly designed for a dealing desk usage only. Furthermore, each ECN has is own trading and order rules, different API specification and FIXcommunication issues. Our tests reported problems with split fills (which MT4 wasn t able to handle), off quotes caused by latency (trades were passed while the price on the ECN had changed), which made possible the use of a bridge in a hybrid model but it was not possible to make it work in a true STP-only model. For that purpose we dismissed the MT4-ECN project and switched to focus our custom software to fill this gap, explains Zagara. I am sure now things have changed; there are different and more powerful bridges. However, in my opinion, I am still very sceptical when I see a broker claiming is offering an MT4 through an ECN. I would scrutinise both the bridge and whether the ECN it connects to was specifically designed or modified to handle MT4-like platforms, to the extent that the benefits of a regular ECN may have been compromised to accommodate the needs of MT4, he warns. Ross Ditlove There are now a lot of brokers that claim to be FX ECNs with MT4, but we review what they are claiming and know that at best, they are simply routing orders out to one destination and again failing the transparency test. Richards adds: There have been many challenges getting this marriage to work. As, in my opinion, the MT4 software was never really meant to execute through an ECN. Currenex, through its executable streaming prices model, is another company making headway in retail ECN trading. If a broker signs on with Currenex they will have true STP-NDD accounts available for their clients, he claims. ECN or not ECN? On what factors may ultimately govern whether a trader should consider using a forex ECN platform or not, Zagara states that while some traders, when delivered a true ECN product, enjoy the liquidity and volatility of these feeds, they are sometimes quickly overwhelmed not only by the commission charges, lower leverage, and higher balance required, but especially with the less user friendly trading platforms that allow you to trade on it. Zagara comments: That reason led us to develop Pathfinder Trader, which includes trading on different ECN s but delivered on a front end with the most advanced features, such as, powerful charting, auto execution, back testing, pattern recognition, and any other advanced functionality you would expect from a modern trading platform. Vedikhin comments: At Alpari (UK) we believe that over 95% of forex retail trading will go through ECN s within the next five years, but there are some obstacles in the way. The first is that ECN trading is often too expensive for the majority of retail traders. Account opening requirements are usually much steeper compared to traditional FX trading, while leverage is much lower. The other obstacle is complexity. ECN s often come across as too complicated and institutional for retail traders. We believe that over time ECN trading will become progressively simpler as users become more informed and educated about its potential. Cost of entry and complexity are both obstacles that can be overcome. While Ditlove notes: We would obviously argue that not using a true ECN platform is at some point detrimental to the trader, but there are still people who view it differently. Our goal is to have a transparent display system that prohibits games, and for some people that have been around a while, the importance of that is lost. Can they make the argument that with a fixed spread, no-commission model it is easier to know what you re getting? Maybe. Is it cost effective and better in the end? I would question whether that is the case. Simply stated, transparency in a market place brings efficiency and efficiency brings value. 134 april 2010 e-forex