Online Internet access has revolutionized how we invest and trade, regardless of the investment medium of our choice, but, have you ever wondered why you cannot buy or sell anything you want from under the roof of a single brokerage house? There are a few exceptions, having more to do with size and capital backing, but the nature of the backroom operations is often the defining reason for broker specialization.
These differences are apparent, especially when you observe how a broker operates behind the scenes in the world of equities versus the world of foreign exchange, or forex for short. The basic mission of a broker in either field, after making a profit for himself, is to provide access to the market for the investor/trader. Markets can either be formal exchanges, where buyers and sellers meet to contract between each other, or they can be informal electronic networks, where the system automatically matches buy/sell orders, based on some accepted methodology.
Stock markets tend to fall in the first category, and in this day and time, stocks, bonds, futures and even financial derivatives can be sold over formal exchanges with the benefit of electronic automation applied where helpful. These exchanges, however, are all about contracts between to parties to shift ownership for a specific asset or security. The contract dictates how title will transfer, be recorded, and how final settlement of funds will occur.
How do these brokers gain access to the market? They can either be an agent of another broker or they can enter an arrangement for direct access from the requisite exchange, typically done when you want to sell securities of any kind. There is one major requirement here that differs from the currency world in that in order to sell directly the specific securities of a corporate client, for example, one must also agree to be what is called a “market maker”.
Per a definition on the web, “A market maker is a bank or brokerage company that stands ready every second of the trading day with a firm ask and bid price.” In other words, if the broker cannot bring a buyer and a seller together, it must step in and be the buyer or seller of last resort. Trading information from a formal exchange can also help track how open execution orders are handled, something missing in the forex sector.
The broker back office is decidedly different in the world of foreign currencies. Currencies are traded in pairs, a majority of which happens on a global and informal network known as the Interbank market. Transactions average $5 million and up, and the market makers here are the banks themselves. All information is proprietary. Major electronic networks, provided by EBS and Reuters, connect these major banks together, and competition and high volume keep trade margins tight and instantly reflective of economic market conditions.
The distinguishing factor here is that the retail forex trader never takes possession of a physical asset. The forex broker contracts with a major bank or broker for access to the market, but the trader only buys a position from the broker. How the forex broker handles his forex risk exposure in the background is between it and its banking partner. Positions are reset every night to prevent crossing the 48-hour (sometimes 24) rule for delivering actual currency. With $4 trillion in daily turnover, there are rarely any liquidity or execution order issues.
These basic differences define the unique skills necessary to run the backroom of a successful stock or forex brokerage firm. Specialization has been the consequence.