Forex brokerages usually operate under the business model of a Liquidity Provider or Market Maker. This article explains how each of these models work and the differences between them.
Forex brokerages can set up their operations using a business model aligned with the way in which they plan to run their business. What this essentially means is that they can either be involved in the trading process or as an intermediary. Brokerages who choose the former route of trading against their clients earn their income from the actual trading that takes place, rather than fees. Those who opt to act as an intermediary, charge traders a fee for allowing them access to liquidity.
These two Forex brokerage models are commonly known as A-book and B-book and refer to the method of processing that takes place.
Market Maker Brokers (B-book)
Market Makers (B-book) operate by taking the other side of their client’s trades. They do not pass the orders to a liquidity provider, although there are some who do earn commission by providing liquidity themselves.
This means that Forex traders who choose a B-book broker will be trading against the broker and any profits generated equate to a loss made by the Forex brokerage. The B-book model provides great opportunities for the brokerage to make a profit, hence many of them opt for this model.
However, brokerages who decide to operate as B-book incur fairly steep costs such as setting up trading desks and algorithmic trading which automatically take the other side of customer’s trades. These costs must be deducted from the profits and therefore affect a brokerage business’s bottom-line.
Liquidity Providers (A-book)
Liquidity providers (A-book) is a generally simpler way to set up a brokerage and as just the intermediary, they enable the trader to access the interbank market by passing the orders to liquidity providers. The best bid ask spread is then transmitted to the clients.
This business model is referred to as A-book processing or Straight Through Processing (STP). In this case, the broker charges a fee and earns on the basis of volume generated by its clients.
Although LPs may not be regarded as profitable as Market Makers, this model of brokerage is known for being more transparent and seen as preferential by many market participants. This business model can also be very successful if the brokerage’s profits are invested carefully with a strategy that focuses on attracting as many active traders as possible and offering additional services to increase their income. A typical example is that some people choose liquidity providers as a data feed provider for obtaining Forex data feed (historical or live) relating to currency pairs for online calculators.
There are also some brokerages who choose a combination of A-book and B-book processing which is known as a hybrid model. This can quite easily be figured out by examining the kind of trading conditions they offer. Brokerages who operate using this model usually categorize traders into two groups, commonly based on factors like size of the trading account and how long they have been trading in the Forex market, for example. Hence, the brokerage offsets a percentage of the trade into the real market (A-book) and warehouses the rest of the trade (B-book).
Generally speaking, both Liquidity Provider and Market Maker models perform more or less the same functions. In deciding which business model to opt for, brokerages are advised to consider both the operational and regulatory aspects of each model beforehand in order to make an informed decision on which model is better suited to their business and which is likely to provide better long-term profit-potential.