Different Types of Brokers
Brokers are intermediaries who execute trades in financial and commodity markets. Institutional FX traders can trade directly either with banks or one another via electronic trading platforms that provide direct market access. Individuals, however, usually need to access the FX market via specialized brokers.
Brokers come in all shapes and sizes, but they can be separated into two major types; principal and agency. Principal brokers operate dealing desks; which price, execute customer trades and hold the resulting positions until the customer trades out of it.
However, the model is rife with potential interest conflicts, primarily that the broker profits when a customer's position loses. This conflict raises perverse incentives into the broker-customer relationship.
This model is similar to the one used by banks to trade with sophisticated market participants. The conflicts are acute when retail FX brokers deploy principal dealing models, which deal with individual traders.
The agency-broker model resembles one used in trading stocks. In this model, the broker acts as the customer's agent, executing transactions on an exchange or other venue. In this model, the broker and the customer's interests are closely aligned.
It is important to research brokers thoroughly before opening a trading account. There are reputable principal brokers who make quality markets. On the other hand, there are proclaimed agency brokers who collect "rebates" from the liquidity partners with whom they execute customer trades. Clearly, these types of arrangements compromise the interest alignment within the agency model.