There is a broker that is¬†currently¬†offering to pay clients if they execute a limit order instead of a market order. ¬†They are an ECN so they just pass on the bank liquidity to their customers and do not mark up the spread like other non-commission and non-ECN brokers do. ¬†The commissions for an executed order are $2.95 per $100,000 traded. ¬†If you input a limit order and it gets filled then they pay you 1.95 per 100,000 traded. ¬†Thus bringing down the total cost of the commission to only $1.00 per $100,000 traded assuming you use limit orders.
I will not discuss which broker it is, ¬†but you can find it by looking around. ¬†I am not here to pump any broker. ¬†I am here to discuss the order flow and liquidity implications and why things happen.
The paying for limit orders is an interesting idea and one that upon closer inspection can help you understand more about the structure of the forex market.
Let me describe you why from their opinion it is a win-win-win situation for all 3 parties involved – the broker, the liquidity provider, and the client.
First we need to go over the three participants in the transactions.
They want to enhance their reputation as a leader in the forex brokerage arena and the paying for executed limit orders gives them a nice marketing tool to use. ¬†This can help them get more customers and attract more liquidity into their platform, and hopefully more commissions. ¬†While the net¬†commissions¬†on the executed limit orders may be lower, the traders will not use limit orders all the time. ¬†Many people will still use stop loss orders, which are market orders and the broker will take the full¬†commissions¬†from there as well.
Liquidity Provider (Banks)
They want to be able to take the orders that they filled on the ECN platform, and hedge them at a profit on another interbank platform. ¬†Or to use the new liquidity provided by the traders inputting limit orders and hedge their orders they received from other platforms onto the ECN with the new found limit order liquidity.
The traders want the fastest possible execution, lowest possible spreads, and lowest possible commissions.
Order Flow and Liquidity Reasons
Why would the brokerage firm be offering such a deal to pay for executed limit orders? ¬†It is obviously an attempt to do two things: ¬†to attract liquidity, and avoid the use of market orders by the traders.
The attraction of liquidity is obvious. ¬†The more traders there are placing limit orders, the tighter the spreads can be, and the more liquidity there is in the system as it is not only the banks providing the liquidity, but there are retail forex traders mixing in their limit orders as well. ¬†So if a situation arises where the banks pull their liquidity, but there still exists some retail limit orders, then they can help fill some customer orders.
The avoiding the use of market orders is the much more interesting part. ¬†From the banks perspective that are providing liquidity, they would rather have customers place limit orders instead of market orders!
The placing of limit orders helps the banks and offers them potential for higher profits or reduced losses. ¬†Why? ¬†Since if there are more limit orders in the system, they can now offload their positions onto your orders, and usually by the time your limit order gets hit, they can¬†instantaneously¬†hedge it for a profit on another platform. ¬†Instantaneously¬†hedging¬†market orders for a profit is much more difficult for them.
I am not exactly sure how it works on the brokers platform, but here is an example:
Example: ¬†Lets say the EUR/USD is trading at 1.3510/11. ¬†The client places a buy limit order at 1.3500 into the ECN system. ¬†As a general rule, you will not get filled until the ASK price hits 1.3500. ¬†So only when the ask price hits 1.3500 does your limit buy order get filled, while the market can be trading at 1.3499/1.3500. ¬†You are long at 1.3500, while the bank just sold short to you at 1.3500. ¬†Now if price can move just slightly below 1.3500, then the bank can make a profit.
So if the price drops down 1 pip to 1.3498/1.3499 then the bank can cover the short at 1.3499 with a market order and make a 1 pip profit, or attempt to cover their trade on another interbank platform. ¬†Or if the market is trading at 1.3499/1.3500, the bank can still cover their short with a market order at 1.3500 for a breakeven trade. ¬†Or the bank can offer to put in a limit order at 1.3499 and see if it can get hit for a 1 pip profit.
Because your buy limit order does not get filled until the ASK/OFFER prices hits your limit order. ¬†While for sell limits, the bid price needs to hit your limit price in order to get filled. ¬†That extra half a pip or 1 pip that the price needs to moves to execute your limit order gives the banks the ability to profit, or get out at break even, or reduce losses. ¬†So it is much better for them if more people place limit orders.
I do not know what type of financial arrangement the liquidity providers have with the ECN brokers. ¬†But it is entirely possible that the banks would be willing to pay the ECN lets say $3 per limit order for $100,000. ¬†Then the ECN brokers goes and gives $2 of those dollars to the traders that execute limit orders as an incentive to add liquidity to the system. ¬†Thus the broker profits $1 per 100,000 in limit orders executed. ¬†This gives the banks the ability to break even on their traders or profit more from them.
After all 1 pip per $100,00 is $10, so if they can make an extra half pip profit from the arrangement on every trade, that is a $5 – $3 that they give to the ECN, so they still end up ahead too by $2 per $100,000 traded. ¬†While the retail traders get an added bonus of being paid for their limit orders and get reduced commissions as a result. ¬†It can be a win-win-win arrangement for the liquidity provider, broker, and retail trader as well.
You have to understand that the banks do not like traders to execute market orders. ¬†If a trader executes a market order, it can mean a few different things. ¬†Either the trader is really smart (informed trader) and knows that the price is going to move very fast and very soon, and thus needs to get an order executed right now. ¬†Thus the bank would be stuck on the wrong side of the informed traders orders. ¬†They prefer to avoid those situations if possible.
Banks do not want to trade with informed traders, because informed traders know where prices are going to move, so if the banks provide informed traders with liquidity, then they can be stuck on the wrong side of the market.
Now, there are traders that execute market orders that do not know what they are doing and they are consistent losers so the bank likes those traders as well. ¬†But those traders do not tend to stay around for very long and blow or deplete their accounts.
While the successful market order traders tend to stay around longer and their accounts grow bigger and bigger, and thus are a threat to the liquidity providers (banks) profits. ¬†Which is why they like the limit orders to balance out and hedge their losses that they may take from providing liquidity to the informed market order traders.
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