Forex Broker: Definition, Role, Regulation, and Compensation

What Is a Forex Broker?

A forex broker is a financial services company that offers a platform to traders who buy and sell foreign currencies.

The clients of a forex broker include retail currency traders who speculate on the direction of currencies as well as financial services firms that trade on behalf of investment banks and other institutional customers.

A forex broker may also be known as a retail forex broker or a currency trading broker.

Understanding Forex Brokers

The foreign exchange market is the largest and most liquid trading market in the world. It runs 24 hours a day, five days a week, and averages over $7.5 trillion in daily volume.

Any individual forex broker firm handles only a small percentage of the overall foreign exchange trading volumes.

Transactions in the forex, or foreign exchange, market are always between a pair of two different currencies. A trader may buy euros with U.S. dollars, for example, and then buy dollars with the euros when the exchange rate tilts favorably.

The Role of a Forex Broker

The majority of foreign exchange transactions occur between currencies that represent the world’s biggest economies. The nations and their currencies include the U.S. dollar (USD), the Euro (EUR), the pound sterling (GBP), the Japanese yen (JPY), the Australian dollar (AUD), the New Zealand dollar (NZD), the Canadian dollar (CAD), and the Swiss franc (CHF).

Most brokers allow customers to trade in other currencies, including those of emerging markets.

How to Trade

Using a forex broker, a trader opens a trade by buying or selling a currency pair and closes the trade by selling or buying the same pair. For example, a trader who wants to exchange euros for U.S. dollars buys the EUR/USD pair. This amounts to buying euros using U.S. dollars.

To close the trade, the trader sells the pair, which is equivalent to buying U.S. dollars with euros.

If the exchange rate is higher when the trader closes the trade, the trader makes a profit. If it is lower, the trader takes a loss.

Opening a Forex Account

Opening a forex trading account these days is quite easy online. The customer will need to make a deposit before making a trade.

Brokers provide leverage to customers so they can trade larger amounts than they have on deposit. Depending on the country the trader is based in, that leverage can be 20 to 400 times the amount deposited in the trading account.

Using leverage greatly increases the risks of forex trading and is a big reason why most traders lose money.

How Forex Brokers Make Money

Forex brokers are compensated in two ways. The first is through the bid-ask spread of a currency pair.

For example, when the Euro-U.S. Dollar pair is priced as 1.20010 bid and 1.20022 ask, the spread between these two prices is .00012, also known as 1.2 pips. When a retail client opens a position at the ask price and later closes it at the bid price, the forex broker will collect that spread amount.

Some brokers charge additional fees. A broker may charge a fee per transaction or a monthly fee for access to trading software. Some have additional fees to trade special products such as exotic options.

Competition among forex brokers is intense and many have been cutting fees to remain competitive. Many brokers now offer free or very low trading fees beyond the spread.

Some forex brokers also make money through their own trading operations. This can be problematic if their trading creates a conflict of interest with their customers. Tougher regulation has helped curtail this practice.

Regulation of Forex Brokers

In the U.S., the industry is regulated by the Commodity Futures Trading Commission (CFTC) and the National Futures Association (NFA).

Anyone considering opening a forex account can research registered brokers through the NFA website or through Investopedia's broker reviews.

The Bottom Line

A forex broker, in modern times, is an electronic platform operated by a financial services firm. Like any online broker, it acts as a middleman between buyers and sellers of currency pairs. Most of the buyers and sellers are professional traders and financial institutions. However, the internet has made it possible for any interested investor to enter this market.