With net capital requirements in the U.S. of $20 million, you may wonder how Forex brokers are able to meet and in some cases exceed this minimum by more than $40 million. While it is no surprise that these brokers are very profitable, most have obtained this war chest by accepting money from outside sources such as private equity groups or hedge funds. What does this mean to you as a Forex trader? More than you think. While having a well capitalized firm makes many traders feel that their capital is safe, most do not consider the pressure that these investment groups apply on these large brokers to maximize the return on their investment.
Just imagine that a broker is required to meet a substantial net capital requirement. That broker will reach out to an investment company like a hedge fund or private equity group to provide the necessary capital needed to satisfy the regulatory capital requirement. In exchange, the investment company will gain an equity stake in the broker. This investment group now has a vested interest in the broker and will have certain expectations in regards to return on their investment.
Again, what does this mean to you as a Forex trader? This means that the broker will need to maximize profitability from every customer of the firm. How do the large brokers maximize profits from accounts with small balances? They act as a market maker which enables them to make money when their customers lose money. Think about it. How much money will a broker make on a $500 account if the client places a few trades and loses a large percentage of their equity? If they charge a commission or capture a mark-up in the spread, maybe $20 or $30. However, if they employ the market maker model (dealing desk) and act the counter-party to their customers' trades, the broker stands to generate much more revenue. How so? If the same $500 account places a few trades utilizing a high level of leverage (200:1 or more) and loses a large percentage of their equity, this amount goes straight to the broker's bottom line. In essence, this represents a difference of $20 (agency model) versus potentially $500. Which model do you think the outside investment company will prefer?
Hopefully this sheds some light that large Forex brokers may not be your best option when choosing a broker. What should you consider when evaluating brokers? First, how do they process trades? Even if a broker claims to not have a dealing desk, don't think that this means your orders are sent to a bank for execution. Most large brokers still employ the market making model even if the claim to not to have a dealing desk. Another important factor to consider is what happens to your funds once they are sent to the broker. Most, even NFA members in the U.S., add your funds to the general ledger of the company and make a journal entry in your account. Finally, and something that most traders don't consider, what is the ownership structure of the broker? Be assured that brokers with outside investors such as private equity groups and hedge funds are interested in maximizing profits from their customer base to appease these investors.