What is a Broker? – Explanation for beginners
What is a broker and how does it work – In the following article, we will explain step by step what is meant by a broker. The word “broker” appears again and again in connection with investing in the financial markets. With more than 8 years of experience in online trading, we have already tested many brokers and providers in the investment field. Learn the most important information today to prepare for your investment.
What you will learn in this article:
- Broker definition
- How does a broker work?
- How does a broker make money?
- Why do you need a broker?
- Types and differences
- Choosing the best broker
Definition of a Broker:
A broker is an intermediary of financial products and investments between the client and the financial market. The broker gives direct access to the markets. Brokers can trade on behalf of a client or let the client trade themselves. This is done through an online platform or instruction by telephone. Likewise, brokers are used to arranging large transactions between different customers.
How to become a Broker?
The term “broker” comes from American usage. There, employees of a financial company are also called brokers. You can call the company a broker or you can call the employee a broker. But I think the best usage is to call the whole company a broker.
In order to become a broker, you can apply for a job at a company that sells financial products, but also real estate salesmen are often called brokers. In this article, we will limit ourselves only to the financial sector. The main task of a broker, who is an employee, is limited to direct sales of products. For this, you need knowledge and skills in “sales”. Depending on the company, most of the time a high degree is not required if you want to join as a broker/salesperson.
If you want to open an online broker or brokerage company you need a lot of capital first. Without starting capital it is impossible to start a broker. The following costs will be incurred:
- Costs for licenses
- Costs for software
- Costs for employees
- Costs for lawyers
- Costs for advertising and marketing
Regulations of most countries prescribe a certain share capital. This is usually an amount of more than $500.000. Behind a broker usually hangs a large infrastructure, which must be planned in detail. The bureaucratic work and verification of licenses will consume the largest amount of money. Brokers are strictly regulated (depending on the country) to prevent fraud and better protect clients. To start a broker, you don’t need extra studies or training. You only need capital and trustworthy partners.
How does a broker work?
The broker has a direct connection to stock exchanges or also sells OTC (over the counter) products. It is not possible to go alone as a private trader to the stock exchange and buy a share. For this, you need the appropriate infrastructure and permission through licenses.
The orders of the customers are directly forwarded to the stock exchange. Through the trading platform, traders can view the current prices and the range of financial products. There are different brokers depending on the offer, but the principle is always the same. The provider distributes the product to the customers and thereby earns a commission/trading fee. In return, the infrastructure and security of the customer’s funds are provided.
In the example below you can see a representation of a Forex broker:
The Forex broker seeks liquidity from various banks or even special providers for it. As a result, the client gets execution at the best prices. Unlike stock trading, Forex trading is not done on an exchange that does the order matching. This is done by the Forex broker and liquidity provider.
Nevertheless, the system is always similar. Liquidity is passed on to the client through the broker. Most brokers try to provide the client with the best execution at the best price.
How does a broker make money?
A broker earns his money through trading commissions. There are always different pricing models for this, depending on the broker:
- Trading commission
- Additional interest income
Most providers work with trading commissions. This means that the customer pays a fixed commission per order or the amount of the trading commission depends on the order size.
For example, there is a fee of 0.1% on the order volume. Now you want to buy shares for 10.000€. So the trading commission is 10€. Or the broker charges a fixed amount that is independent of the order volume. For example, you always pay 3€ per order.
The spread is mostly used in forex and CFD trading to make money as a broker. An additional bid and ask spread is added to the current price. So the trader gets a worse execution at a worse price. The difference from the current price is the broker’s profit. Due to high volatility, the spread can fluctuate with any broker, as too little liquidity is offered.
Another income of the broker can be a financing fee. However, this only applies to leveraged financial products that are held overnight. Margin trading is performed with leverage. The broker basically lends the trader money for larger positions. It is a loan, so to speak. This is financed by the client with a fee. The broker usually borrows the money from larger banks and lends the money to the client for higher interest. The difference is the profit of the provider.
Why do I need a broker?
As mentioned above, you need a license to buy securities. For Germany, for example, this would be a license/registration from the Federal Financial Supervisory Authority (BaFin). In the USA the broker would need regulation of the Financial Industry Regulatory Authority (FINRA). Also, most countries have more than one regulatory authority.
As an investor, you cannot buy securities directly on the stock exchange. There is intermediation. A high level of security and a smooth process should be guaranteed. This is done by the broker. The Odermatching at the stock exchange is very complicated and works in millisecond intervals. Millions of funds/trading volume can be transferred per second. The matching infrastructure is provided by the broker.
Types and differences between Brokers
In general, it is necessary to distinguish between financial products and brokers. For example, there are only pure stockbrokers or pure Forex brokers. However, many providers do not limit themselves only to financial products but offer a wide range of investment opportunities.
We have already written articles about the following brokers:
Multi-asset brokers are very popular with the average investor and trader. There is usually an offering of over 10,000 different markets. The largest multi-asset broker is Interactive Brokers. With this provider, you can actually trade all financial products that are available to retail investors worldwide. A multi-asset broker is not always the best choice for traders who know exactly what they want to trade. Brokers that specialize in a particular product can usually offer better conditions than a multi-asset broker.
With stock brokers, you can buy and sell securities. An important criterion for this broker is also the choice. There are countless stock exchanges worldwide. For example, if you want to buy stocks from Russia, not every stockbroker offers that. Therefore, you should know which offer is available at the Anbierter before signing up.
Cryptocurrencies are usually offered on unregulated platforms. However, the broker industry is not idle and is now increasingly trying to offer regulated trading in cryptocurrencies. This is done either via derivative or direct coin. There is still a lot of growth and undiscovered opportunities in this market segment.
Forex and CFD Brokers
Forex and CFDs are usually offered together by one broker. They are also derivatives that are traded with leverage. You can trade CFDs (contracts for difference) on actually all markets. The advantage lies in the leverage and the possibility of short selling as well. It is an easy and fast way to enter the markets. Forex and CFD brokers secure themselves in the background with external market makers who have the appropriate licenses for this.
Futures (forward contracts) are traded transparently on the stock exchange. For futures, there are also very many specialized brokers that offer an easy way to this financial product. The fees are very low and the leverage is high. For futures contracts, you need larger amounts of money. It is not recommended for the beginner, because you are forced to trade with large positions, because there are no smaller ones. The financial product was developed for hedging for the economy. However, many traders speculate about these contracts because they are transparent and liquid. Futures are also available for very many markets. Speculations on rising and falling prices are possible.
How to choose the best broker:
Unfortunately, there are always brokers that are not good or even dubious. Watch out on the Internet for scam websites disguised as brokers. You can even find copied websites of brokers trying to get customer funds over and over again. So always be careful from the start which website and platform you want to use.
Generally, it is recommended to use a broker that has been in business for several years and has good ratings. The fee structure and service should also be scrutinized. Broker selection is one of the most important tasks of an investor. The broker is instrumental to a large extent in the profits of the trader.
Our checklist for a good provider:
- Check the regulation of the provider
- What experience does the provider already have?
- Check the selection of markets and assets
- What are the costs per trade?
- Are there any additional costs?
- What trading platform is offered?
- Support and service for customers
- Deposit and withdrawal options
Check the above points whenever you choose a broker.
Use a demo account
Another important point to find the best broker is a demo account. Most brokers offer a free demo account to test their services. This is a virtual account with credit. So you trade with play money and imitate real money trading. I advise every new trader to use the demo account first before investing with real money.
Our conclusion on the broker – A fiercely competitive business model.
On this page, we have given you an insight into the world of brokers. Brokers sometimes have a bad reputation because of dubious business practices, so it is even more important to choose a good provider.
Brokers make money by charging trading fees. In return, they provide infrastructure and services to their clients. It is a legitimate and lucrative business. However, competitive pressure is also very strong in the industry. A bad broker will only be able to survive on the market for a few months. As a broker, you can earn a lot of money, but the cost is also very high.