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 holds above 1.0700 ahead of key US data
EUR/USD trades in a tight range above 1.0700 in the early European session on Friday. The US Dollar struggles to gather strength ahead of key PCE Price Index data, the Fed's preferred gauge of inflation, and helps the pair hold its ground.
GBP/USD trades on a softer note below 1.2530 ahead of US PCE data
GBP/USD trades on a weaker note around 1.2502 during the early Asian trading hours on Friday. The modest rebound of the US Dollar weighs on the major pair despite weaker US GDP growth numbers. The US Personal Consumption Expenditures Price Index data on Friday will be in the spotlight.
USD/JPY stays above 156.00 after BoJ Governor Ueda's comments
USD/JPY holds above 156.00 after surging above this level with the initial reaction to the Bank of Japan's decision to leave the policy settings unchanged. BoJ Governor said weak Yen was not impacting prices but added that they will watch FX developments closely.
Editors’ Picks
EUR/USD holds above 1.0700 ahead of key US data
EUR/USD trades in a tight range above 1.0700 in the early European session on Friday. The US Dollar struggles to gather strength ahead of key PCE Price Index data, the Fed's preferred gauge of inflation, and helps the pair hold its ground.
USD/JPY stays above 156.00 after BoJ Governor Ueda's comments
USD/JPY holds above 156.00 after surging above this level with the initial reaction to the Bank of Japan's decision to leave the policy settings unchanged. BoJ Governor said weak Yen was not impacting prices but added that they will watch FX developments closely.
Gold price oscillates in a range as the focus remains glued to the US PCE Price Index
Gold price struggles to attract any meaningful buyers amid the emergence of fresh USD buying. Bets that the Fed will keep rates higher for longer amid sticky inflation help revive the USD demand.
Sei Price Prediction: SEI is in the zone of interest after a 10% leap
Sei price has been in recovery mode for almost ten days now, following a fall of almost 65% beginning in mid-March. While the SEI bulls continue to show strength, the uptrend could prove premature as massive bearish sentiment hovers above the altcoin’s price.
US core PCE inflation set to signal firm price pressures as markets delay Federal Reserve rate cut bets
The core PCE Price Index, which excludes volatile food and energy prices, is seen as the more influential measure of inflation in terms of Fed positioning. The index is forecast to rise 0.3% on a monthly basis in March, matching February’s increase.
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