When trading forex, you are speculating on the future direction of currencies, taking either a long (“buy”) or short (“sell”) position depending on whether you think a currency pair’s exchange rate will go up or down.
Specifically, you seek to profit from fluctuations in the exchange rates between currencies, betting on whether one currency’s value, like the Japanese yen, will go up or down in relation to another, such as the Australian dollar.
Price movements in the forex market are triggered by currencies either strengthening (price appreciation) or weakening (price depreciation).
Your ability to open AND close trades is limited to the prices that your forex broker offers to you, as there is no other market for these trades.
So now the question is…
How do you know the prices that YOU see on your broker’s trading platform are an accurate reflection of what’s happening in the “real”(institutional) forex market?
Let’s review one part of the earlier story between Batman and Spiderman:
The game works like this: Try to guess if the GBP/USD exchange rate will go up or down. Let’s say the current exchange rate is 1.4000. Do you think it will go up or down?
Notice how Spider-Man just seemed to make up a price for GBP/USD?
Fortunately, Batman didn’t just take Spider-Man’s word for it and used his Batphone to verify the price with a third-party source.
If you’re not familiar with the story above, this means you haven’t read our earlier lesson on How Forex Brokers (Kinda) Work. It’s highly recommended that you read this lesson first.
Like Batman, you should wonder about the same thing regarding forex brokers.
Where do the forex broker’s prices come from? Are the prices accurate?
For any given currency pair, your forex broker will quote you two prices:
- A higher price (“ASK”) at which you can buy (“go long”)
- A lower price (“BID”) at which you can sell (“go short”)
Collectively, the ASK and BID prices are referred to as the forex broker’s “price” to you.
The difference between the lower and the higher price is known as the spread.
You see these quotes on your trading platform (or “customer terminal”). These quotes displayed are known as a “price stream”.
But where do the prices come from?
Does the forex broker just make them up?
It’s possible. 😱
But highly unlikely.
Now you might be thinking, “Huh? It’s possible?” but…
Did you know that your forex broker may show ANY prices it wishes?
As we covered in a previous lesson about the FX market, retail traders can’t trade in the institutional or “interbank” FX market. We’re deemed uncreditworthy (“too poor”). So ff you want to speculate on currency exchange rates, you need to find a retail forex broker.
The forex broker “makes a forex market” for you to trade in.
This is either in the form of CFDs (if you’re outside the U.S.) or rolling spot FX contracts (if you’re in the U.S.). Which together, can simply be called retail “FX contracts“.
These contracts involve only two parties: you and the forex broker.
And since these contracts are created by the forex broker, it can technically quote whatever bid and ask prices it wants. And it’s up to you to choose whether you’ll trade at those prices.
How and where a forex broker sources its prices is totally up to its discretion.
On its trading platform, it may show you prices derived from outside sources or it may not.
This means that prices offered by your forex broker may or may not reflect prices available elsewhere such as from another forex broker.
Why is this the case?
Shouldn’t the prices quoted by the forex broker be identical to the prices in the underlying (institutional) FX market?
And there lies the problem.
In the FX market, for each currency pair, there is no such thing as one “market price”.
The FX market is what’s called an “over-the-counter” or OTC market.
In an OTC market, there is no centralized “place” where all market participants gather and can see the same SINGLE market price.
How Pricing Works on Exchanges
To help you better understand why it’s important to understand the significance of the FX market being an OTC market, let’s compare this to an exchange-based market like the U.S. stock market.
One of the founding principles of an exchange-based market is it must offer fair and equal access to all participants. Exchanges publish quotes for everyone to see and trade.
To understand this better, let’s quickly look at how pricing works in the U.S. stock exchanges:
When a trade occurs, an exchange reports the trade to a consolidated data feed called the SIP (Securities Information Processor), which disseminates the data.
For example, when the NYSE executes a trade to buy Apple shares, it reports the trade to a SIP.
In addition to trades, the best bid and ask prices on different trading venues are shared with the public to the SIP.
The SIP then combines all quotes to determine National Best Bid and Offer (NBBO).
This data consolidation takes place very quickly. The average time it takes for SIPs to gather, consolidate, and disseminate a trade report is around 17 microseconds (millionths of a second).
To put that in perspective, a human blink of an eye takes 100 milliseconds (a tenth of a second) or 100,000 microseconds! This means that pricing data updates in less than 0.017% of the time it takes to blink an eye!
The NBBO is extremely important as it tells traders the price at which they ALL can buy and sell at that moment.
In 2005, the SEC passed the Regulation National Market System, known as RegNMS, requiring brokers to obtain “best execution” for all orders within the NBBO. Basically, RegNMS obligates brokers to route orders to the venue offering the best price (which is based on NBBO).
The advantage of having consolidated data in the U.S. stock market is that the NBBO provides unambiguous “reference” prices that allow all traders to assess whether they got fair pricing.
The NBBO allows everyone to know the best bid and offer for every exchange-listed stock regardless of what venue they are posted on, all less than a millisecond after the quotes change.
This provides fair and equal pricing for all traders, both large and small.
All traders are protected by the prices that the exchange shows because EVERY trade must occur at prices no worse than the NBBO at the time the trade was executed.
How Pricing Works in the Forex Market
In an exchange-based market, there is a “single market” that allows everyone to all interact at the same prices.
In contrast, the FX market does not operate in a centralized public exchange. There is no “single market” which means there is no single “market price”.
There is no equivalent of a data feed like SIP that consolidates all the trades that occur and the best bid/ask prices that are quoted.
This means that the forex market does NOT have the equivalent of an NBBO for each currency pair that would provide an unambiguous “reference” price that every forex broker would have to adhere to.
How Retail Forex Brokers Source Their Prices
Reputable forex brokers will base their price on the prices of other FX participants, usually banks and other non-bank financial institutions (NBFIs) from the institutional FX market.
These market participants are known as liquidity providers (LPs).
A group of liquidity providers (LPs) is known as a liquidity pool.
It is these prices that the forex broker uses as a REFERENCE price of an underlying currency pair. Or at least, should be using.
As mentioned earlier, a forex broker will quote you two different prices for a currency pair: the bid and ask price.
You see these quotes on your trading platform (or “customer terminal”). These quotes arriving are known as a “price stream”.
The price that YOU see is based on prices that your broker obtains from these liquidity providers.
The broker has a pool of multiple LPs from which it receives pricing for the various currency pair it offers.
The forex broker aggregates or collects these prices in real-time to find the best available bid and ask price.
Both prices do not necessarily have to come from the same LP. For example, the best available bid price may come from one LP, while the best available ask price may come from another LP.
The aggregated prices are fed into a “pricing engine” which streams prices (your “price stream“) to your trading platform.
The price that YOU see will usually have a markup added (unless you’re paying commission).
Theoretically, this should all be an automated process where the broker has neither control over the selection of the best available price from the pool of liquidity providers (LPs) nor can it manually intervene to alter any prices streamed to the trading platform (aside from adding a markup).
Just because two traders use the same broker, it doesn’t automatically mean they both see the same bid and ask prices in their price stream. Different customers may be quoted different prices. It depends on how how brokers profile their customers and if the price engine is configured to vary pricing by profile. This is konwn as “price discrimination“. Ask your broker if it price discriminates between customers.
Every reputable forex broker displays to YOU “their” price based on what liquidity they have access to.
What liquidity they have access to depends on their liquidity providers (LPs).
Forex brokers who are large enough to have a prime broker (PB) can access a mix of different liquidity providers such as Tier-1 banks, ECNs, and aggregators.
Most of the global FX liquidity is provided by large banks with dedicated FX departments and are referred to as “Tier-1” liquidity providers. This “Tier 1” group of liquidity providers is made up of names such as Bank of America, Barclays, BNP Paribas, Citi, Commerzbank, Credit Suisse, Deutsche Bank, Goldman Sachs, HSBC, J.P Morgan, Nomura, Société Générale, and UBS.
By connecting themselves to multiple LPs, these larger forex brokers can improve their prices and offer their customers the best available bid and best ask prices from among the LPs.
When multiple liquidity providers stream their bid and ask prices, the broker’s “price engine” selects the best bid and ask price, which results in the best available spread.
Theoretically, the collective trading volume of the broker’s customers encourages price competition among the LPs.
Each LP is competing to be the forex broker’s hedging counterparty so this provides the leverage to demand better pricing.
Having multiple liquidity providers is also important especially during abnormal market conditions, such as during times of extreme volatility, when some liquidity providers may decide to widen the spreads or stop quoting prices altogether.
For A-Book brokers, this is crucial since their execution model is totally dependent on liquidity providers being available to provide quality liquidity even during volatile or illiquid market conditions.
Smaller forex brokers source their pricing by connecting to an aggregated liquidity feed provided by a Prime of Prime (“PoP”), and sometimes in conjunction with other non-bank liquidity providers (“NBLPs”) who are known as “electronic market makers”.
Examples of electronic market makers that are active in the FX markets are XTX Markets, Citadel Securities, Virtu Financial, Global Trading Systems, HC Technologies, and Jump Trading.
PoP providers have prime broker (PB) relationships with major banks which give them the ability to aggregate prices from multiple LPs and distribute them to smaller forex brokers.
Do you see bank logos on a forex broker’s website? If you see the logos of the big banks (Barclays, Citi, UBS, etc.) displayed on a retail forex broker’s website, don’t believe the hype. Due to their small size, most retail forex brokers don’t have direct relationships with these “Tier 1” liquidity providers. Only the largest forex brokers with PB relationships can claim this. The rest have to rely on a PoP and it is the PoP, not the broker, who should be displaying the bank logos.
Be Careful of Price Manipulation
Potential conflicts of interest arise from the lack of transparency in the pricing of FX contracts.
It is not always clear whether the pricing is actually linked to an underlying market and it’s hard to verify.
Your forex broker may establish its prices by offering quotes from third-party prices, but it is under no obligation to do so or to continue to do so.
Some forex brokers may even require their customers to acknowledge that the reference prices used to determine the value of the underlying asset (e.g. currency pairs) may differ from the price available in the market.
As a consequence, traders often find it difficult to verify the accuracy of the prices shown to them on the broker’s trading platform.
For example, you can see the prices on your trading platform that your broker quotes, but unless you also have other trading platforms open from other brokers, it’s hard to compare quotes.
This makes any open or pending positions vulnerable to price manipulation.
For example, traders have complained of forex brokers altering prices at their own discretion to either cancel a winning trade to avoid payout or close trades to realize customer losses.
Volatile market conditions provide the perfect opportunities for price manipulation and “stop hunting”, where a broker closes a trader’s position to make a profit for itself.
If you place stop-loss or take-profit orders, since the broker knows exactly where these orders are, it can manipulate its so-called “market price” to hit your stop-loss or miss your take-profit price. This means the broker wins or avoids a loss.
While this practice is not as common as it once was, it still continues with shady brokers who operate in unregulated or minimally regulated jurisdictions.
If a broker is under a regulatory jurisdiction with minimal (or no) transaction reporting requirements, it can be very hard to prove, which is why it still continues today.
Another complaint involves brokers engaging in asymmetric slippage practices.
“Slippage” refers to instances where the price at which the order is executed differs from the price quoted (for a market order) or the price requested (for stop-loss or take-profit orders).
A huge amount of slippage can occur during breaking news or when a major economic data report is released.
A broker can introduce “asymmetric” slippage into the order execution where if price benefits the broker, it’ll execute. But if it doesn’t, then the price is slipped and requoted with another price that favors the broker.
And if the market moves where it benefits you, the broker won’t execute your order with the price improvement.
How to Make Sure You Get Fair Pricing
As retail traders, we expect that the prices quoted will closely follow the underlying market.
But how similar these prices are to the “market” depends on the forex broker.
Forex brokers adopt a degree of discretion in price setting, especially during periods of high market volatility.
This use of discretion is what causes some retail forex and CFD trading platforms to have an unclear and confusing pricing methodology.
A pricing methodology is the process or procedure used by a forex broker to determine what prices to show its customers.
There have been instances where customers of certain forex brokers have filed formal complaints to regulatory agencies about unfair pricing practices.
Examples of complaints include:
- How the prices were not determined fairly and customers were shown prices that were not even close to the prevailing market price at the time a trade was made!
- How the forex broker unfairly exercised its own discretion to close out positions of its customers resulting in realized losses!
The problem is that prices are not readily verifiable as there is a lack of transparency surrounding the process in which retail forex brokers and CFD providers display prices to their customers.
Here are some online resources that you can use to gauge how close the prices your forex broker offers to what others are offering:
Remember, since the FX market is an OTC market, there is no single price. So while prices may not be exactly the same, they should only deviate by a tiny bit. A pip or less, depending on the currency pair.
How can you be sure you are getting the best pricing available and prices are not being manipulated by your broker?
If the broker claims that you are trading prices directly sourced from their liquidity providers, can they provide you with EVIDENCE?
Retail forex and CFD trading platforms should be able to clearly explain how it determines their prices, including:
- How it uses non-affiliated third-party liquidity providers (LPs) to derive its prices
- How it uses independent and externally verifiable price sources to ensure prices from LPs closely follow prevailing market prices
- How it applies any spread or markup.
The pricing and spreads should be set via price competition from multiple liquidity providers (LPs).
But that’s not all.
Ask your broker how often they review their price providers.
Brokers should be comparing the pricing provided by their liquidity providers against external price sources, both in real-time for actual prices and at least on a weekly basis for average prices.
This helps to ensure that there aren’t significant deviations from the “market prices” in the pricing quoted to customers.
In cases where the price is outside acceptable predetermined parameters, the broker should have systems in place where it is alerted immediately so it can investigate and take immediate action.
Make sure to ask what these “acceptable predetermined parameters” are.
Lastly, the forex broker should be able to provide you a written policy clearly explaining its price methodology, on how it opens and closes CFDs (or rolling spot FX contracts) honestly and fairly.
The policy should also cover any circumstances under which its prices will deviate from its stated pricing methodology.
If the broker can’t provide you with their pricing methodology, look for one who can.