Following up on How to tell if a broker is regulated, here’s the answer to another classic: is my forex “broker” really a broker, or a dealing desk?
NB: if you’re unsure why brokers and dealers (market makers) tick differently, watch this webinar. All we do here is get the regulator to tell you what’s what, in language meant for traders, not lawyers. Our goal is to explain stuff clearly, but if you think any of the below is incorrect or misleading, comment below & accept our apologies!
1. Activities: certain financial activities fall within the regulated perimeter – i.e. to carry them out, persons have to 1) apply for regulatory permission and 2) agree to abide by the regulations. These include, amongst others, whom you employ (are they fit and proper?), how you advertise, how much regulatory capital you must hold, your internal processes, etc.
2. Instruments: not all financial instruments are equally risky – thus the regulator verifies on what instruments the regulated person is fit to carry out the regulated activity
3. Customer type: not all customers are equally vulnerable to financial abuse. Goldman Sachs can reasonably be expected to know the risks in trading with leverage, in a way that e.g. your average 93 year old pensioner cannot.
Because one of the goals of regulation is protect vulnerable economic agents from unfair treatment – the demands on agents offering trading of high risk instruments are proportionately higher.
Right! Why, then, does someone like Darwinex claim to be a broker, but carry permission to deal as principal?
Because spot foreign exchange or contracts for difference, or spread-bets are traded over the counter. OTC instruments are not available from any of the Exchanges recognised by the FCA, so there’s NO organised market for an agent to source them for you. To get around this, every European broker (even agency-only ones) offering OTC instruments needs permission to “Deal in investments as principal”.
So, every European forex / CFD / spreadbetting broker could be trading against me?
NO! Some remain agency only by limiting their dealing in investments as principal permission with a “matched-principal” restriction (click on the image below to visit Darwinex’s regulatory profile) as per below.
This imposes on Brokers the “matched-principal” trade flow:
1. Customer goes LONG 1 Lot EURUSD…
2. Broker goes SHORT 1 Lot EURUSD (using the “Dealing in Investments as Principal” permission)…
3. At the same time, matched-principal brokers go LONG 1 Lot EURUSD against independent liquidity providers – aka “the market”.
Note that all a dealer could do to internalise the customer P&L (internalise = fancy word to say that dealers win when customers lose, and viceversa) is NOT enter the matched-principal, market facing trade leg. With a matched-principal broker, after the third “with-customer” trade leg:
1.The customer is LONG the EURUSD.
2. The market is SHORT the EURUSD against the customer, via the broker
3. The matched-principal-broker is trading with the customer, against the market. At heart, he remains an agent despite acting as a principal on the customer leg. This is the only way to source OTC investments on a pure agency basis in Europe
As a relevant side-note, notice the nuance on incentives:
1. First order, the broker doesn’t care how the EURUSD moves, as his P&L is the net offset of 2 other principals (customer and market). This is the reason why pure brokers trade market risk for counterparty risk – and if you want to understand the implications watch this.)
2. Second order, brokers prefer winning customers – they trade bigger volumes, for longer than losing customers, which means more commission
That’s it: to tell a dealer from a broker, all it takes is ask the FCA.
No matched-principal restriction? It’s a dealing-desk / market maker / dealer. By the way, the FCA requires 5 times more regulatory base capital from dealers than for matched principal brokers. If told by a “broker” that they carry the dealing permission just in case, you know the next question to ask.
NB: if you’re unsure why brokers and dealers (market makers) tick differently, watch this webinar. All we do here is get the regulator to tell you what’s what, in language meant for traders, not lawyers. Our goal is to explain stuff clearly, but if you think any of the below is incorrect or misleading, comment below & accept our apologies!
A (minimal!) primer on European MiFID regulation
Broadly speaking, European MiFID regulation involves 3 dimensions when it comes to trading:1. Activities: certain financial activities fall within the regulated perimeter – i.e. to carry them out, persons have to 1) apply for regulatory permission and 2) agree to abide by the regulations. These include, amongst others, whom you employ (are they fit and proper?), how you advertise, how much regulatory capital you must hold, your internal processes, etc.
2. Instruments: not all financial instruments are equally risky – thus the regulator verifies on what instruments the regulated person is fit to carry out the regulated activity
3. Customer type: not all customers are equally vulnerable to financial abuse. Goldman Sachs can reasonably be expected to know the risks in trading with leverage, in a way that e.g. your average 93 year old pensioner cannot.
Because one of the goals of regulation is protect vulnerable economic agents from unfair treatment – the demands on agents offering trading of high risk instruments are proportionately higher.
Broker activities & permissions
The minimum set of regulated activities – and therefore, MiFID permissions – involved in legally operating a European brokerage are:- Agreeing to carry on a regulated activity –
- Making arrangements with a view to transactions in investments
- Arranging (bringing about) deals in investments
- Arranging safeguarding and administration of assets
- Dealing in investments as agent
- Dealing in investments as principal
- Given you’re looking for a broker, did you spot the odd permission out?
Brokers dealing as Principals???
A broker ought to be an agent – not a principal – to customer trades! Surely anyone dealing in investments as Principal can’t be a broker?Right! Why, then, does someone like Darwinex claim to be a broker, but carry permission to deal as principal?
Because spot foreign exchange or contracts for difference, or spread-bets are traded over the counter. OTC instruments are not available from any of the Exchanges recognised by the FCA, so there’s NO organised market for an agent to source them for you. To get around this, every European broker (even agency-only ones) offering OTC instruments needs permission to “Deal in investments as principal”.
So, every European forex / CFD / spreadbetting broker could be trading against me?
NO! Some remain agency only by limiting their dealing in investments as principal permission with a “matched-principal” restriction (click on the image below to visit Darwinex’s regulatory profile) as per below.
This imposes on Brokers the “matched-principal” trade flow:
1. Customer goes LONG 1 Lot EURUSD…
2. Broker goes SHORT 1 Lot EURUSD (using the “Dealing in Investments as Principal” permission)…
3. At the same time, matched-principal brokers go LONG 1 Lot EURUSD against independent liquidity providers – aka “the market”.
Note that all a dealer could do to internalise the customer P&L (internalise = fancy word to say that dealers win when customers lose, and viceversa) is NOT enter the matched-principal, market facing trade leg. With a matched-principal broker, after the third “with-customer” trade leg:
1.The customer is LONG the EURUSD.
2. The market is SHORT the EURUSD against the customer, via the broker
3. The matched-principal-broker is trading with the customer, against the market. At heart, he remains an agent despite acting as a principal on the customer leg. This is the only way to source OTC investments on a pure agency basis in Europe
As a relevant side-note, notice the nuance on incentives:
1. First order, the broker doesn’t care how the EURUSD moves, as his P&L is the net offset of 2 other principals (customer and market). This is the reason why pure brokers trade market risk for counterparty risk – and if you want to understand the implications watch this.)
2. Second order, brokers prefer winning customers – they trade bigger volumes, for longer than losing customers, which means more commission
That’s it: to tell a dealer from a broker, all it takes is ask the FCA.
No matched-principal restriction? It’s a dealing-desk / market maker / dealer. By the way, the FCA requires 5 times more regulatory base capital from dealers than for matched principal brokers. If told by a “broker” that they carry the dealing permission just in case, you know the next question to ask.
Editors’ Picks
EUR/USD flirts with daily highs, retargets 1.1900
EUR/USD regains upside traction, returning to the 1.1880 zone and refocusing its attention to the key 1.1900 barrier. The pair’s slight gains comes against the backdrop of a humble decline in the US Dollar as investors continue to assess the latest US CPI readings and the potential Fed’s rate path.
GBP/USD remains well bid around 1.3650
GBP/USD maintains its upside momentum in place, hovering around daily highs near 1.3650 and setting aside part of the recent three-day drop. Cable’s improved sentiment comes on the back of the Greenback’s irresolute price action, while recent hawkish comments from the BoE’s Pill also collaborate with the uptick.
USD/JPY edges up above 153.50 with all eyes on US CPI figures
USD/JPY appreciates above 153.00 but remains on track for a 2.4% weekly loss. Trading volumes remain subdued on Friday, ahead of the IS CPI release. The Yen remains supported by hopes of a stable government and calls for further BoJ tightening.
Editors’ Picks
EUR/USD: Yes, the US economy is resilient – No, that won’t save the US Dollar Premium
Some impressive US data should have resulted in a much stronger USD. Well, it didn’t happen. The EUR/USD pair closed a third consecutive week little changed, a handful of pips above the 1.1800 mark.
Gold: Metals remain vulnerable to broad market mood Premium
Gold (XAU/USD) started the week on a bullish note and climbed above $5,000 before declining sharply and erasing its weekly gains on Thursday, only to recover heading into the weekend.
GBP/USD: Pound Sterling remains below 1.3700 ahead of UK inflation test Premium
The Pound Sterling (GBP) failed to resist at higher levels against the US Dollar (USD), but buyers held their ground amid a US data-busy blockbuster week.
Bitcoin: BTC bears aren’t done yet
Bitcoin (BTC) price slips below $67,000 at the time of writing on Friday, remaining under pressure and extending losses of nearly 5% so far this week.
US Dollar: Big in Japan Premium
The US Dollar (USD) resumed its yearly downtrend this week, slipping back to two-week troughs just to bounce back a tad in the second half of the week.
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