The purest form of a Forex broker? An honest opinion on the ECN model

• Brief historical notes
• Implementation of the ECN model: a valid alternative, and the price of progress
  • Liquidity aggregation tool
  • Revenue model
• What are the benefits of the ECN/STP model?
  • The ethical aspect
  • The legal aspect
  • The risk management aspect
  • The technological aspect
• Final thoughts

The ECN model is referred to as the most conflict-free and advanced in the Forex market. And while few would argue with that, many companies still adhere to the market maker model. Without accusing or pointing fingers, we will again define what is the ECN model, and analyze through our experience, why the transition to the electronic communication network model is not that easy, and why most brokerage businesses out there may actually benefit by applying the ECN/STP concept to their platform.

Brief historical notes

The mainstreaming of FX ECN accounts began approximately in 2009-2010. It was then, on a wave of traders' frustration, that Forex market maker brokers first felt a tangible leakage of clients.  What was the reason for the frustration? First of all, the practices used by dishonest companies. The vast majority of market maker brokers were like casinos, which are known to play against their clients. And when customers win, casinos lose money.

When Forex brokers' clients began accumulating experience en masse, a large number of successful traders appeared in the market. When the conflict between brokers and their clients entered a sharp phase, ECN accounts, which excluded the very reason for the conflict, started to gain popularity. ECN brokers were completely transparent and guaranteed every transaction of their clients, but they were still in the minority.

Be that as it may, the cat was out of the bag, and the truth about what a pure market-maker broker really was, could no longer be concealed. The companies practicing such a model had only two ways to keep the interest of their clients: sophisticated promotions and bonuses or switching to the ECN system. However, as it became clear from experience, not all of them chose the latter way. In the following section, we will try to figure out why some companies are reluctant to follow the progress and what types of Forex brokers are really interested in the functional concept of ECN.

Implementation of the ECN model: a valid alternative, and the price of progress

Before we talk about what tasks face a company choosing to implement the ECN system, let's break down the concept itself. Probably, the reader already has some understanding of how ECN brokers work, but in the context of this publication, it is important to consider how we look at the problem.

In the ECN-model, liquidity on the trading platform is generated by all participants in the trading network. The process of matching their orders with each other is called internalization because it happens within the platform and is not exposed to external execution. But remember, this is not to be confused with the market maker execution model where the quotations flow is basically imitated, and the other party to the transaction is the broker.

That said, emerging businesses that use the ECN model may not always experience sufficient liquidity inflows to support proper order execution. They can benefit from the ECN/STP model, which, in our opinion, is one of the main attributes that distinguish the advanced and versatile broker. Now let’s break down why we persist in the opinion.

To begin with, we would like to emphasize that we do not consider the 'ECN vs STP' paradigm to be constructive. The main difference between ECN and STP broker models lies in the transaction routing. But here's the thing — the ECN/STP model turns this difference into an advantage.

So what is ECN in a nutshell? The ECN, or electronic communication network model, as a rule, is based on a technological solution, which provides matching orders of all network participants, including banks, centralized exchanges, companies providing services on OTC, as well as private clients.

The concept of STP means that the broker sends all orders to external execution without interfering with the process, and all transactions are performed at maximum speed. An ECN/STP broker, therefore, takes the best of both worlds, generating quality internal liquidity and having access to risk hedging from external sources.

Under the ECN/STP model, the money is still on the side of liquidity providers, whether these providers are coming from the inside network or connected externally. Brokers generate income from the commissions, or fees that are charged on each client transaction. Consequently, the ECN/STP model imposes potential requirements on the company, which must be met in order to comply with the status of a progressive broker.

Liquidity aggregation tool

As already mentioned, liquidity in the ECN/STP model is generated by market participants, with the potential to connect external sources. To manage this process, you need both a technical solution with a matching engine to combine orders, and resources to collaborate with a reliable liquidity provider from the external market. These two components will ensure that you achieve important goals: provide your platform with commission-free liquidity through internalization, get additional liquidity through connections to external sources, and warehouse the risks of client trades, if necessary.

Revenue model

Unlike market makers, brokers using electronic communication network scheme do not incur losses from well-performing clients, but there is an emerging view that the fee-based earning model may bring less revenue to a platform with a small and medium number of clients. In any case, this is worth having in mind when calculating a long-term business strategy.

What are the benefits of the ECN/STP model?

Taking into account the information above, we can conclude that the transition to the ECN/STP model for some FX companies can be very tangible, if not even painful, from a financial and technological standpoint. Nevertheless, the model has some unconditional advantages which attract a certain category of market players.

The ethical aspect

An FX broker who only makes money on commissions from orders is motivated to make sure that clients are trading and generating ever-increasing volume. This is the main point in the confidence-building strategy between the client and the trading platform, and it always looks favorable in an advertising campaign. Therefore, the ethical meaning of the ECN model lies in the fact it represents the definition of a reliable and trustworthy broker.

The legal aspect

Due to the profit generation model, it is much easier for ECN/STP brokers to obtain a license from well-known jurisdictions. On the contrary, a market-making company that plans to register somewhere except offshore will most likely have to prepare a large security deposit and submit regular reports to the regulator, which also entails additional costs.

The risk management aspect

The FX market is saturated with ultra-volatile assets, and the aspect of risk hedging is particularly relevant for brokers who include in their portfolio such instruments as, for example, cryptocurrencies. The ECN/STP model eliminates the scenario where sharp movements in asset prices can take down a brokerage business, as all prices are determined by liquidity providers.

The technological aspect

As a rule, the software that is used to support a healthy FX ECN/STP model has many additional features that greatly simplify liquidity management. One of them is the ability to partially lay off excess risk to external liquidity providers when needed. And the word ‘partially’ can mean the smallest shares of in-house trades.

Final thoughts

In the end, the trading and technological infrastructure of a brokerage are determined by an analysis of the target audience, as well as the desired ratio of risks and profits. Only after that, you look into the difference between execution models. At the same time, in our honest opinion, the ECN/STP model can offer the most advanced components of modern brokerage, and freedom of choosing how exactly you want to supply your liquidity depending on the situation at hand. We at Soft-FX are ready to prove it to you by the example of our products and solutions.