The main function of forex brokers is to act as intermediaries between the FX trader and the interbank system, to use the technical term.
The interbank system refers to all the major banks and their connections where they send money to each other. Today, this is all digitized and happens electronically. But, since this system is for banks only, someone has to facilitate our connection to the system.
Major banks provide FX brokers with liquidity and pricing, which they then pass on to their customers. The currency marketplace is dominated by the major players, namely banks and institutions.
Forex brokers serve as a way to connect the retail FX trader or investor into the larger marketplace. This is because major banks are not interested in dealing with the “small” amounts of money that an individual FX trader would put into the market.
Accessing the Marketplace
Having an account with a forex broker means you can use your investment or speculation capital to buy and sell pairs of currencies.
This happens in two ways: opening a buy by purchasing one side of a currency pair with the other. For example, buying EUR with USD. By later doing the inverse and buying USD with EUR you close the transaction and accrue your profit or loss depending on the movement of the currencies while the buy was open.
Or, you can go in the opposite direction. This is when you sell EUR in exchange for USD. After the currency moves – hopefully, in your favor – you instruct your forex broker to close the position by buying EUR with the USD you have.
Security is Important
While these two practices are their main function, many forex brokers also offer other products.
For practical purposes as an FX trader, the broker acts as an intermediary between you and someone who wants to do the opposite trade as you. If you want to buy GBP, for example, the broker connects you to someone who wants to sell.
Additionally, the forex broker, by guaranteeing that you will honor your side of the trade with the funds in your account, also guarantees that the other FX trader will honor their side of the trade as well.
Reputable brokers are able to do this by having to guarantee available funds before joining the interbank system. They also only deal with other reputable forex brokers and banks.
Another important service for the forex market that brokers provide is substantial leverage.
Leverage is when the broker loans you money to invest through the broker, using your account as collateral. What this means is that you can multiply your forex trading potential by up to hundreds of times.
For example, say you want to trade $20, and your broker provides you with an account that is leveraged at 1:100. That means for the $20 that you put into your trade, your forex broker will loan you $1,980 in order to complete $2,000. In other words, 100 times the amount you put in. This allows you to make significantly larger trades.
Because of leverage, you can make more money on your trades, but you can also lose more money as well. This is why it’s essential to always assess your risk and practice money management to protect the funds in your account.
What Do They Get Out of It?
The way reputable forex brokers typically make money is through the bid-ask spread.
When they take your order and pass it through to the marketplace, they offer you a price that has a small difference between the asking price and the bidding price.
For example, EUR/USD 1.110/1.1102 means that there is a .0002 spread or 2 pips difference between the buying price and the selling price of that pair of currencies. This spread is what the forex broker collects as profit, avoiding using fixed price commissions. The spread can vary depending on the platform and market conditions like supply and demand.
The spread is easily digestible and transparent for FX traders and investors. This is why it’s the preferred system among reputable brokers. Because retail traders generally prefer to take advantage of significantly larger moves, the size of the spread is relatively small compared to the trader’s profitability. It’s also readily available information before you make trades. That being said, additional fees may also apply, such as swaps.
Some forex brokers may charge a fee per transaction or a monthly fee for access to a particular software interface. However, with high levels of competition, there is a drive to offer the most attractive service to the customer.
That means that most brokers minimize or completely eliminate all fees other than the spread. Usually the bigger the broker, the more they can take advantage of economies of scale. And the better ability they have to offer products without additional fees!
Before FX traders jump in and invest their savings or speculation capital, they can access demo accounts.
These accounts have minimal requirements and enable you to practice trading with no risk. It’s very handy to get a feel for both the market and the platform you are going to operate on. That way, you can track your progress and know when you are ready to start investing real money into forex trading.
Almost every experienced, successful FX trader not only started with a demo account but usually will keep at least one demo account even while trading real money. This allows you to practice strategies in real-time, test new ideas, and learn more about the market.
Providing Access to Information and Tracking
The final key function that brokers perform is directing market information and tracking to the FX trader.
Most brokers provide a wealth of information to their traders on all the relevant variables required to make trades. At the same time, you can analyze and track your progress and results.
It’s vital to be informed both before making a move and also after. This is so you can refine your process and make your next trading session better than the one before.
Successful FX traders are always honing their skills and absorbing new information. Most forex brokers make money when their traders do, so they are interested in helping their customers succeed.
If you are starting out with forex trading, you might want to consider working with a broker that provides comprehensive educational materials to help you get started and advance in your trading.
Remember that investing in the markets is always risky. Therefore, risk mitigation strategies are often the key to long term success in forex.