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2010-01-21 08:52 by Karl Denninger
in Regulatory Ignore this thread
More On Forex Trading and Brokerages*

My "Reform to Kill Retail F/X" article got a few people's blood pressure up... 

It appears that my central point wasn't well-communicated based on the comments I've received (including in places that I don't have "commenting" accounts), so I'll try again.

Here's the central point:

The brokerages all claim to be "commission-free" but this is not really true - the fees charged, instead of being in the form of a traditional commission, are in the form of "pips" or a spread, and on a position held open the spread is charged again and again as a "rollover fee." 

The key item is that since this is an over-the-counter market you do not know what the actual market price is at any given point in time, and therefore you do not know what the commission is that you're being charged as it is (intentionally) hidden from you.

The number of people who said "oh you only pay the spread once" are sadly delusional.  In a regulated exchange market where national best bid and offer (NBBO) is visible to you you can typically "split the baby" between bid and offer, or even occasionally get filled "wrong way" in the spread as someone will occasionally "pick off" your bid or offer.  Further, your broker is typically either restricted or prohibited entirely from taking the other side of the trade internally with you.  In the case of Globex futures the rule is that before your broker can "cross" your order internally (e.g. for another client) they must expose your order to the market for a minimum period of time.

In other words, the broker doesn't get the spread, the guy on the other side of the trade does!  Half the time (on average) that's you. 

This is not true if you can't see the market depth and are in fact buying or selling on whatever spread you're presented by the broker instead of the market itself - he may be (and probably is) padding the actual market spread materially on both sides.

These rules, along with the inherent characteristics of an exchange (that is, the visibility of the bid and offer stack at any given point in time) means that a brokerage has to expose their commission and fee structure - how they actually make money - in a form you can see it.

Again: In an OTC market this is not true as what you are provided as a bid and offer is only what the broker wants you to see and may have no relationship to the best bid and offer they can find in the marketplace.

This is the inherent screw job in OTC derivative contracts - OTC Forex - or OTC anything.  The lack of a regulated, public exchange where you as a customer can see the various bids and offers in the marketplace means that you as a customer will always be disadvantaged as the broker you're doing business with has every incentive to skim from you by concealing the actual market depth.

Of course the Forex Dealers don't want this to change.  They don't like the idea of a regulated exchange for the same reason that the banks don't like that concept for CDS.  Their business model depends on obscurity to maximize their profit, and it is extremely difficult if not impossible for a customer to know whether they're getting a good deal or literally bent over the table in any particular instance.  Further, it is entirely possible for one client to get a "good deal" and another "be screwed" - and again, the lack of an exchange and thus central posting of bids, offers and trades makes it essentially impossible for you as a customer to know if you're being treated fairly or not.

There is no such thing as a free lunch in lending, brokerage or anything else. 

My central point by weighing in on this issue is that the customer is never in a better position when one has an OTC market with no public visibility versus an open, exchange-traded market and that as I have noted nobody ever works for free.

The bottom line is this: If you can't figure out how someone's making their cut of the transaction your most-reasonable assumption is that the means by which they make their money, and the amount they're skimming off your transaction, is being concealed from you for the express purpose of allowing them to maximize their take.

That is, when you look around and can't find a sucker you need only find the closest mirror to locate the person who's on the short end of the stick.

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