Breaking Good: How to Select a Broker

Selecting a Broker

Stock brokers have been around for quite some time. In fact, they are mentioned as far back as the 2nd Century BC in Rome, where – students of our earlier courses will remember – the government issued the first shares to help pay for public works. They returned to prominence during the Renaissance, when the Italian city state of Genoa issued its first municipal bonds and the French began trading agricultural debt, and again soon after in the 17th Century, when the Dutch and the British issued their first publicly traded shares. In fact, the first stock exchange, established in the coffee houses of London in 1801, were created, not by investors, but by brokers.

Today’s financial markets are populated by two distinct trading entities: business-to-business (B-2-B), which encompasses trading between major investment banks and brokers trading between themselves, and business-to-consumer (B-2-C), which comprises retail (individuals) and institutional (funds, insurance companies, etc.) clients trading through the former B2B group, who act as intermediaries.

Before we continue, we should distinguish between brokers, who serve as intermediaries between buyers and sellers, and agents, who represent one of two trading partners.

Going for Broke

In the early 1900s, brokers began quoting both buy and sell prices for assets, enabling them to profit from the spread and creating the entity we call a market maker. The market maker holds on to a purchased security until a buyer is found or – alternatively – guarantees a sale price to a buyer before the required asset has been purchased. Indeed, when dealing in non-physical assets, especially those that are not traded in exchanges but over-the-counter, the B2B market operates as an exchange; and online trading facilitates these informal exchanges, as they gradually transform into a feasible alternative to national primary/secondary-market exchanges.

Today, the two tasks – broker and market maker – are required by law to be carefully separated – especially in firms that perform both tasks.

The first online brokerage was TradePlus, which was established in 1985. Today, many traditional brokers allow their clients to trade  independently using online trading platforms. In fact, an increasing number of brokers have shifted to an online approach, providing their clients with platforms, through which they can place orders and trade in real time. Indeed, the online industry has been so successful that, during this time, the flood of burgeoning online brokers has only been stimmied by increasingly strict regulation on the part of government and monetary institutions. However, regulators have shown a clear preference for online trading, which is easier to monitor; moreover, online brokers more readily generate long-term reports for their own purposes, rather than as a requirement of the regulator.

Concurrently, with the advent of cryptocurrencies, online crowd-funding and a host of other innovations, the online trading environment is – as yet – clearly in its nascent stage.

Do You Need a Broker

Unless you are personally licensed to trade on an exchange, the answer here is quite simply: YES! A broker provides access, and – even if you are licensed – the cost of investing through one is often considerably cheaper.

But beyond this, when travelling the financial markets, especially now that this activity is becoming more and more democratized, the individual retail investor cannot be expected to maintain the level of proficiency required of professional traders; thus it is highly advisable to invest through someone whose job it is to keep an eye on a specific market/sector/ class/asset. On the other hand, we have seen time and again (the Wall Street collapse of 1929 and the financial meltdown of 2008) that brokerage and investment bank employees are often liable to keep their eyes on the interests of their employers instead of – and sometimes at the expense of – their clients.

And thus, the first question a trader should ask him/herself is where the trade-off between maximum transparency and independence, on one hand, and reliance on expertise, on the other, should be situated. Obviously, this is a question that can only be answered by the investor: how much time is he (or, increasingly, she) willing to spend on research and analysis, what is his risk-aversion level, and more. And, consequently, what kind of broker is he actually looking for – a broker dealer who trades sometimes for himself and sometimes for a set of clients, a discount brokerage, a prime brokerage, an over-the-counter brokerage, an exchange brokerage, or an online/ discount brokerage firm.

Your Wish is Your Responsibility

All of these questions lead us to the first and most important question you must be asking yourself: Why are you interested in financial markets? Are you an adventurer-slash-gambler seeking thrills? Are you fascinated by the interaction between the news and financial markets? Or are you a freelancer without an employer putting aside a portion of your salary for your retirement fund?

Each of these questions will lead to a subset of characterizations regarding your risk level, your need to save and increase your money value, your willingness and available time required to learn the markets and study them on a regular basis.

Careful attention to these details will serve as a road map to the rest of this process.

Market Makers, Liquidity Providers and ECNs, oh my!

For traders who are not actually purchasing shares or physical assets, such as gold, oil, coffee or lean hogs, the terms market maker and liquidity provider will sooner or later cross your attention. What kind of broker are you dealing with? Are your positions covered? Is he safe?

In order to gauge your broker’s reliability, it is important to understand these terms.

Since most traders have neither the ready cash or inclination to actually buy shares (an expensive venture that entails taxation, high commissions and relatively high stakes) or oil (a venture that requires lots of storage space), derivatives are the most feasibly traded instrument. In 2008, a Deutsche Bank white paper estimated that the €457 trillion global market in derivatives was “more than four times larger than the combined global equity and bond markets (as) measured by market capitalization.”

Market Makers

A market maker is a broker who either retains a sufficient inventory of a specific asset in order to quote buy and sell prices for it and serve as a trader’s counterparty for that asset. A corollary of that inventory is the increased traffic which that broker administers in that asset, thus enabling even more traffic. Many stock exchanges approve designated market makers to guarantee liquidity in specific assets and asset classes. Otherwise, a market maker will rely upon a liquidity provider to hedge his risk.

When a market maker buys and sells assets for its own inventory, it is performing a principal trade, which appears on its A-Book; when it buys or sells from its clients, it is performing an agency trade, which appears on its B-Book. Thus, the market maker ensures the availability of a specific asset at a specified price, enabling swift execution without waiting for an independent counterparty for each trade.

It becomes immediately evident that market makers must be able at all times to cover their commitments towards the traders who rely upon them. To do that, they must hedge their risk with a liquidity provider – hedging positions to lower risk… just like any responsible trader should be doing vis-à-vis each and every one of his own trades.

Liquidity Providers

Liquidity providers are often referred to as market makers who specialize in a specific asset class. Thus, we will refer here mainly to Tier-1 liquidity providers – the ones who primarily underwrite forex transactions but also provide the necessary liquidity to market makers so that the latter will be able to honour their commitments. These include Germany’s Commerzbank and Deutshce Bank, BNP Paribas in France, HSBC in the UK, Citibank in the US, Namura in Japan, and similar others.

Liquidity providers also provide liquidity to smaller banks and commercial forex companies. They offer much lower spreads, since they rely on much higher trading volumes per client; however, they will only enter into a relationship with an established institution that can demonstrate financial soundness – either a designated market maker or a prime broker.

ECN

The interaction between liquidity providers and market makers takes place over an Electronic Communications Network (ECN). These ECNs are – to the inter-broker/liquidity provider market – what electronic trading systems are to traditional (primary, national, stock and commodities) exchanges. Some brokers will enable their clients to enter this network directly and trade opposite the major players (the banks, investment houses, etc.). This is often referred to as Straight-Through Processing (STP). In this case, the broker will usually not be deriving any profit from the spreads but instead charging a commission on each trade.

The disadvantage for the client is that he no longer has a guarantor for his position, but must risk slower execution (the market maker, by serving as the counterparty, offers immediate execution) and slippage – the difference between the expected price of a trade and the actual execution price. This becomes a problem when markets are extremely volatile or when limit orders prevent execution (an especially dire risk in a stop-loss, for example).

The major advantage is more transparent pricing and lower spreads –  a boon for professional traders with large portfolios. 

What is an Online Brokerage?

An online broker – sometimes referred to as discount broker – is a firm that provides a trading platform to its clients through which they can trade. In most cases, the broker operates as a market maker – offering buy and sell prices and acting as a counterparty to the client; in some cases, they offer the client access to an ECN (electronic communications network) system that enables direct trading vis-à-vis the company’s liquidity providers.

In both cases, the broker provides access to an online platform through which trades are executed. Examples of such platforms include MT4, NetDania and AvaOptions – platforms that also offer technical analysis tools, in-depth reports, back testing, strategy testing, and more.

Regulation

Following the Dot-Com bubble and, more recently, the 2008 meltdown, regulators around the world have realized that the scope for fraud in the financial sector is immense. In Europe, the European Union’s European Securities and Markets Authority (ESMA) recently enacted the second in its tranches of regulations (MiFID-2 – Markets in Financial Instruments Directive no. 2) aimed at battling money laundering, fraud and irresponsible behaviour. Recognizing that a large part of the 2008 crisis stemmed from a lack of transparency on the part of traditional financial services companies, it has levied upon them a set of regulations that require huge data resources, thus creating an inherent preference for online brokers; however, these brokers must themselves prove that they too are playing on a level field. Leverage has been lowered, dangerous instruments carefully limited, and many promotional practices abolished.

Thus, the first thing to ensure when selecting a broker is that he is regulated!

If a broker is regulated in more than one region, this is further proof of their reliability, since that broker’s practices must abide with more sets of regulations. And since few firms will administer multiple systems, clients enjoy the protection of the most stringent set of regulations to which the broker subscribes, regardless of which system he belongs to, by stint of location.

Regulatory conditions differ from place to place. In the US, for example, most online brokers are heavily integrated into the traditional bricks-&-mortar industry; in many cases, they are simply subsidiaries of larger investment firms. Thus, their regulation by the SEC (Securities Exchange Commission) lags behind that of Europe, especially insofar as technology is involved. In Europe, on the other hand, regulations must be enacted that will satisfy the requirements of all member states – each with its own history of financial dealings, each with its own set of curbs and concerns.

Security

Money is a serious business, and no Brinks truck would be protected by a bearded old sclerotic brandishing a plastic slingshot. Similarly, responsible brokers will safeguard their clients’ funds to the best of their abilities: it’s in their interest to do so. Every so often the financial services industry publishes the latest standards; and based on these, brokers safeguard their clients’ money and trading data.

Most regulators require that client funds be kept in dedicated accounts that are separated from the bank accounts used by the brokerage for its regular running expenses. They should be inaccessible to the broker except for the purposes of executing your trades, and they should be kept and maintained in tier-1 banks only. On the information level, various protocols exist. Find out which is used by your preferred broker and Google it!

Funding Transactions

The most often heard complaint about brokerages is the time lag involved in withdrawing funds. Obviously, depositing is rarely a problem, and one that usually comes down to the variety of payment platforms accepted. Nowadays, most brokers accept any list of credit, debit, e-cash or e-wallet cards, as well as wire transfers and more. The question arises, how swift is the withdrawal process. Here, though, too fast is sometimes an indication of carelessness. A major portion of MiFID-1’s regulations were aimed against money laundering and funding for terrorist organizations. Thus arose the KYC (Know Your Client) process of establishing a client’s identity. No company will enable a withdrawal if the slightest suspicion arises regarding a client’s true identity or intent to launder money.

Here, the simplest test is to open an account, deposit the minimum requirement, and then ask for a full withdrawal. Then, judge the process for yourself. If you begin receiving phone calls aimed at changing your mind, continue elsewhere (after insisting on a full refund and complaining to the authorities if you feel you are being obstructed). In the US, and with some managed funds, there is also the possibility of linking a personal bank account to your trading account, thus facilitating immediate transactions. Remember, though, that often a payment to and from a credit card account entails the use of a 3rd party payment facilitator. Find out which provider the broker works with and Google that company. You will quickly discover if there is any litigation pending.

Seniority, Experience & Reputation

Considering the upheavals of the past decade or so, chances are that any company that has weathered the regulatory storm is a safe one. Scam brokers that burgeoned during the Binary Options period exist no longer, since this particular instrument has been banned for retail investors. Moreover, the information age ensures that any broker who is not up to par will soon be published as such on the plethora of sites dedicated to broker policing and comparisons.

Smaller companies that arose during the mushrooming period of online brokers have either consolidated or disappeared, especially with the lowering of leverage levels. To succeed financially, brokers must now compete on service and charges – a business model that can only apply to larger and more established firms.

Tip number 2: Research your broker. Do a simple Google search, paying special attention to sites such as Forex Peace Army.

Clearly, some policing sites are scams themselves; i.e. they have either been created by a specific broker or else they sell media space to advertisers. Moreover, since the more dependable sites do not provide anonymous reviews but rather actual complaints, the thing to remember is that complaints will always exist (especially emanating from untrained traders who have lost their money); the question is, how does the company deal with those complaints.

Charges & Commissions

If you intend to trade shares, the price per transaction or price per share traded are important to examine, since these can be quite high (especially considering the actual costs and taxes required by the state or exchange). In this case, try to gauge how many trades you will perform per month and of what size. Find a broker whose billing structure best suits your requirements. Some brokers will offer discounts based on transaction volume, others based on your account balance.

For those who are not especially attracted to actually owning shares, bars of gold or barrels of oil, most retail brokers who deal in derivatives do not charge commissions; instead, they profit from the spread. This is a good thing for several reasons, primarily since this model clearly motivates brokers to extend their clients’ “shelf life” as long as possible. What that means is that a reputable broker will want his client to succeed and thereby execute as many trades as possible. As soon as the client loses his money or transfers in frustration to another company, he represents lost income. Since the spread represents the difference between buy and sell prices, the more trades executed, the better it is for the broker.

From the trader’s point of view, the spread is the primary basis for comparison between brokers. Given all else being equal, who charges the lower spread on a particular instrument? Professional day-traders, for example, will have several accounts with different brokers – opening a specific trade with a specific broker based on his particular spread for that particular instrument at any specific moment. For example, one broker may have a lower spread on Euro-dollars one day and on Pound-yen the next, while another might be a better venue for investing in Alibaba.

Tip nuber 3: After deciding what assets interest you the most, follow the assets information pages for several brokers over a limited period, and see who seems to be the best fit.

The same should be examined for rollover fees (overnight swaps).

Another aspect to monitor is the minimum investment required to open an account. Is there a maintenance fee charged for low balance or account inactivity?

Platform

Gone are the days when one needs to pay $15,000 a year to access the Bloomberg Terminal. Most of today’s professional platforms provide access to market and news alerts, analytic tools and more. Of these, we can divide the horizon along several slices: online or downloaded, PC-based or mobile, proprietary or generic.

Of the generic downloaded platforms, MT4 is by far the most popular, with NetDania providing an ever growing alternative, especially considering its informational components. Nearly all platforms receive real-time feeds from licensed feed providers, such as Thompson Reuters in the case of MT4. And since attempting to doctor the data is discoverable within milli-seconds, it pays to incorporate one of the Big-3. Most companies also have their own proprietary platforms, some even having platforms dedicated to particular instrument types, such as AvaTrade’s desktop and mobile versions of AvaOptions for trading vanilla options.

Insofar as charting and analysis tools, the more the better. Also, check to see if the bank of technical indicators, for example, is easily expanded. How complicated is it to set up an alert or watch list? How comprehensive is a called-up position in the archive? Will it show a development chart? Provide key moments?

Tip number 4: Check the platforms on site, perhaps even open a demo account to get the feel for it.

What assets does the platform offer? At least as a beginner you may not want to concentrate on a specific asset class; indeed, focusing on a specific should be a self-learning experience, and you may not want to be limited by the platform’s offerings.

Education & Information

Most online brokerage sites provide several pages of daily analysis – fundamental, technical, written, video. However, according to regulatory rules, they may not offer actual investment advice. Many brokers have scaled that wall by turning to 3rd party providers for education, information and even trading signals. These are services that – independently purchased – can be a costly outlay. Trading academies cost hundreds of dollars; trading signals – possibly more. It often pays to subscribe to a broker who offers both for free.

Tip number 5: Find a broker who provides access to reputable information companies; it’s worth maintaining a minimum balance to receive free signals daily from companies such as Trading Central, Auto-Chartist and others. It’s certainly worth it if you are getting access to an academy such as this one for free!

Before we continue, a word on promotions.

Don’t.

Thankfully, MiFID-2 severely restricts the kind of regular emails your broker may send you. When signing up, check to see if the broker incorporates a double-opt-in sequence for receiving emails. This is now a requirement. Bonuses have been abolished by the European regulator, except under severely restrictive conditions. And if you being receiving such mails before you have even opened an active account:

Close It!

Support

Finally, make sure that your broker has an easily accessible, human, customer support service in your language. Since support here is on both the administrative and professional level, make sure that your account manager is more than simply a sales person, but one who understands the basics of financial markets. If that person represents himself as a professional trader, ask for proof of professional affiliation. A professional trader should be able to produce proof of having worked for a major investment firm, trading in assets, perhaps
even specializing in a specific class. Such affiliations are usually recorded by the local securities authority. Search for records of extended down-time in the system. These could sometimes be due to technical upgrades – on one hand, a sign of a company keeping up its technological edge, on the other, a test of technological savvy.

Remember, a company’s investment in customer support is often an excellent gauge for measuring how important you are to him. Sloppy support could mean they may be interested in your money more than they are in you.

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