Scalping in forex is a prominent method of trading due to the realization of quick profits and the frequent number of opportunities. Fortunately, many brokers are accommodating to discretionary and mechanical methods for execution, scalping included.
However, a few of them might still explicitly prohibit scalping, and rarely do they explain why. While scalpers are spoilt for choice with brokers, it’s useful to know why some might have reservations about this trading style.
Although many traders don’t scalp the markets, this article will hopefully prove educational and provide more details about what happens in the back end from the broker’s perspective. We can sum up the main reason for several brokers prohibiting scalping as primarily a logistical and infrastructural one.
The two main execution models by forex brokers
It’s important to consider scalping itself is not an illegal practice in most countries, which is why the vast majority of providers allow this approach. Another erroneous misconception is brokers ‘hating’ scalpers.
Regardless of a broker’s execution model, they all desire to retain their clients for as long as possible. To understand why some providers might not like scalping, we need to examine the two primary mechanisms of providing market access to traders: the ECN/STP and the market maker or dealing desk system.
With the STP (Straight-Through Processing) model, the provider simply passes their clients’ orders in numerous ECNs (electronic communication networks) to the interbank market without any intervention.
For their efforts, they will mark up the spread between the buying and selling prices they receive from these liquidity providers once the most competitive quote for the position has been found.
As a business, profiting from these small fees means high volume becomes essential. Thus, such providers don’t limit the trade frequency because of the financial incentive and not be responsible for providing liquidity.
However, dealing desks operate differently since they essentially take on the risk of being the liquidity provider themselves rather than relying on the interbank market.
The main problem scalpers pose for some dealing desk brokers
It’s crucial to start with the fact most brokers nowadays technically operate between the two models. Very few will admit they are actually ‘market makers’ due to the negative perception this has built over the years in the trading world.
Since forex is decentralized, this is further compounded as we can never know exactly where orders are directed to and who might be ‘on the other side.’ Moreover, many brokers who might be dealing desks don’t limit trading methods like scalping or hedging.
Still, a few do decidedly ban such approaches, which all comes down to the logistics of hedging positions. A dealing desk broker provides liquidity in two ways. The first is by matching their users’ orders against each other.
For instance, if one trader wants to buy EUR/USD and another wants to sell the same pair, the broker will match the two and profit from the spread in between. The second technique, which is more challenging and risky, is used when the broker cannot match amongst its users.
The broker will basically hedge in a secondary market by buying the euros and putting them in their ‘inventory.’ In both scenarios, the firm wants to have an even number of buyers and sellers across a range of instruments to produce a ‘balanced book.’
Unfortunately, because of the rapid nature of scalping, it becomes tricky for some brokers to match a trader’s orders in a fluid manner consistently. If we multiply this across thousands of other clients who might be trading with a particular provider, it’s clear to witness a logistical problem that leaves the broker vulnerable to net exposure risks.
Other reasons why scalping is an issue for some dealing desk brokers
The scenarios explained above are common for brokers who don’t have the infrastructure to handle scalping. In reality, many providers who are dealing desks can hedge a substantial amount of orders. So, the problem itself can be both logistical and infrastructural.
Research suggests some brokers might have a lagging price feed and fear scalpers with an updated feed might have an advantage for arbitrage. Arbitrage refers to the practice of quickly buying and selling the same instrument offered by two different providers with slightly different prices.
This is also a form of scalping and is considered abusive, more so for market maker brokers. Overall, it makes it difficult for such providers to hedge and manage these kinds of positions because of their frequent nature.
Final word
Brokers who provide direct market access make the bulk of their money from spreads. Because they don’t have the arduousness of ‘making a market’ for their traders, they can process a seemingly infinite number of orders daily without any challenges.
In contrast, this is not possible for some dealing desk brokers, especially if they don’t have the right infrastructure. Fortunately, the vast majority of the larger brokers, regardless of how they process orders, have no issues with scalping. Nonetheless, it’s still helpful to check whether some exceptions exist.
This article should have also highlighted dealing desk brokers overall aren’t inherently malicious and that most providers do use this model. However, the point is to note a few providers do have their own way of conducting business and do not want to mitigate the risks coming from having scalping clients.
