How Do Liquidity Providers Make Money and Are They Market Makers?
I&8217;ve already talked about the difference of the true and false or fake ECN/STP brokers. Make sure not to miss these posts, because they are very important for someone like you who wants to make a living through trading: The Difference of True and False ECN/STP Brokers
As you have learned from this article, an ECN/STP broker is the one that routes the traders&8217; orders to one liquidity provider at least, without any human intervention. If that liquidity provider is a well-known and trusted organization like Nomura or Deutsche Bank, then the broker is a true ECN/STP broker that doesn&8217;t manipulate your trades and doesn&8217;t trade against you.
Now, the question is whether the liquidity providers go against you, or they are happy with the spread and swap they make out of your positions? Is the spread and swap the only income source of liquidity providers or they have some other ways to make money? Do good liquidity providers bother to make you lose, the way market maker brokers do?
Liquidity providing and the spread and swap the liquidity providers earn through this service is only one of the income sources that famous liquidity providers have. They offer too many other services and have too many investment activities.
Like a market maker broker, they lose money when you win. However, as they are too big and offer their services to numerous companies and clients, the small losses are always recovered by the profits they make.
More than 95% of the traders lose and so their money stays in the liquidity provider&8217;s pocket. But the difference of a big liquidity provider like Deutsche Bank with a market maker broker is that they are too big and they make much more profit through the services they offer. Therefore, they don&8217;t bother to make retail traders lose.
Even if you make them lose, they still appreciate your business, because the money you transfer to them and stays with them when you take and hold your position will be added to their treasury and they use it for too many other purposes.
At the same time that you buy a currency, they sell another currency to someone else. They buy and sell stocks and shares. They lend money to big investors, other banks and organizations, and even governments, and they earn a lot of profit.
Your money helps them handle all these activities, and they help you trade. They handle millions of transactions 24 hours per day and 7 days per week, even when the currency market is closed to retail traders on weekends.
So, it doesn&8217;t make sense for them to go against the traders and make them lose. They usually don&8217;t do it, because they don&8217;t have to. Besides, they are always worried about competition and so they have to offer a better service every second. Just a small mistake can ruin their credit and cause them to lose a lot of business. On the other hand, they are closely supervised by the governments and if they make any mistakes, they will have to pay for it badly.
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Liquidity Providers and True ECN/STP Brokers Relationship
Unlike market maker brokers, true ECN/STP brokers route the traders&8217; orders to interbanks that are also known as liquidity providers: The Difference of True and False ECN/STP Brokers
So, true ECN/STP brokers are just mediators. They charge a small fee for each transaction. This fee is called commission which is the only legal and legitimate way for these brokers to make money. They don&8217;t make any money from the traders losses, nor they lose any money if traders win.
Nowadays, almost all the true ECN/STP brokers are connected to several strong and famous liquidity providers, whereas in the past they were used to work with only one or a few. These are some of the most famous liquidity providers: Bank of America, Goldman Sachs, JP Morgan, Citi Bank, Nomura, HSBC, Deutsche Bank, Royal Bank, TD Bank, Barclays, Wells Fargo
When a trader clicks on the buy or sell button, the broker chooses one of the liquidity providers that is offering the best price which is the closest to the price that the trader sees on the broker&8217;s platform. Then the broker transfers the order to that liquidity provider. Each of the liquidity providers can offer a price which is usually different from what the traders see on the platform, because the platform&8217;s price can be from only one price resource, not from all the liquidity providers. Therefore, when the order is placed, your entry price will be different from what it was when you clicked on the buy/sell button. This difference can be from a few pips to several pips depend on the market condition. But it is too close to the platform&8217;s price 99% of the time.
The order will be placed when the liquidity provider accepts it. They usually accept the orders most of the time, unless the order is too big and the market is not liquid enough or is too liquid and volatile.
Let&8217;s say your order is placed. The question is whether the liquidity provider knows you as the trader or not. Does it know that which order is placed by which trader?
The answer is, liquidity providers only know the brokers. From their point of view, it is the broker that is placing the orders, not you. They don&8217;t know the retail traders. A broker can have thousands of open positions with each liquidity provider at the same time.
What the difference does this make to you?
The more you know about the brokers and liquidity providers, the easier you can choose a good broker who is honest and doesn&8217;t lie to its clients.
Some brokers say that they don&8217;t allow the liquidity providers to see the stop loss, target and pending orders, because they don&8217;t want them to know the profitable traders and prevent them from making profit. As I mentioned, liquidity providers don&8217;t know the traders. They only know the broker and the positions it takes. As over 95% of the traders always lose, then 95% of the orders that a broker routes to each liquidity provider are losing orders. So there is no point to prevent the winning positions, because the liquidity providers make enough money through the losing positions, and many other things: How Do the Liquidity Providers Make Money?
Also, as brokers scatter the orders among several liquidity providers, then each liquidity provider will have an equal share from the losing and winning orders that each broker sends, and they will not be under the attack of too many winning positions at the same time. This is really good for traders.
Each broker has an account with each liquidity provider, exactly like the account a trader has with the broker. Liquidity providers offer a 100:1 leverage to brokers (of course the famous and strong liquidity providers I listed above, not a small and unknown bank at the middle of Pacific Ocean, or a marker maker retail broker that also offers a liquidity providing service to the other brokers).
Brokers have to deposit enough money to the accounts they have with the liquidity providers. They have to top up their accounts when their clients (traders) lose money, otherwise they can reach the margin call and stop out level. If so, their clients will not be able to place any new orders, and the liquidity provider starts closing the losing positions. This is what a broker never wants to happen, because it will have a very bad impression on the traders minds. They will ask why the negative positions are closed while they still had enough money in their accounts. This is a right question, because the traders had money in their accounts, but it was the broker that didn&8217;t have enough money in the account it has with the liquidity provider. Traders don&8217;t know what is going on behind the scene. They only see the positions that are closed without any reason.
So, the money that a true ECN/STP broker takes from its clients, has to be deposited in the account the broker has with the liquidity providers. Usually they place 50% of the money they take from the clients. As their income, they deduct the commission they make from the orders.
A true ECN/STP broker has to be careful not to overspend the money it takes from the clients, because a too strong market movement can suddenly take the broker account balance down, and so, the broker will have to top up the account immediately before it reaches the stop out and margin call levels. They need money to do that. If they spent the money for the other purposes like office expenses, salaries, advertisement and&8230;, they will get into serious problems.
Sometimes, a too strong market movement causes some positions to have negative balances. It is the broker who has to pay this balance to the liquidity providers, not the traders. But it is the traders who have to pay their negative balance to the broker. However, traders usually walk away and will never pay for the negative balance. The broker will have to prosecute each trader, which will be too expensive. So the broker prefers to shut down and get out of the game. They can get prosecuted by the liquidity providers too. It depends on the contract they have with each other. These are all possibilities. They usually don&8217;t happen even once every 10 years.
Now, I am going to ask you some questions. The best answer will be rewarded with 1000 points. Here is the question:
100:1 is the maximum leverage that liquidity providers offer to the true ECN/STP brokers. What happens if a true ECN/STP broker offers a higher leverage, like 500:1, to its clients? How the orders will be handled then, and who will be the loser or winner if this leverage difference causes any losses or gains?
What happens if a true ECN/STP broker offers a lower leverage, like 50:1, to its clients?