Origins of Forex Spreads — From Banks to You
The Bid and Ask is fundamental to any price quote. We all wish we could trade at mids but that isn’t the reality we live in (despite what some Forex brokers say). This brief introduction is meant to be accessible for all traders. Read on for all you ever wanted to know about Forex spreads from the market makers to retail traders.
Where Spreads Come From
Currency trading, Forex, FX, however you prefer to call it doesn’t exist on an exchange. It is quite possibly the world’s largest market and it’s all over the counter (OTC). Every major bank has their own FX desk usually separated between voice traders and an electronic execution team. Accompanying each group are sales and support staff as well as tech, back office and a myriad of other departments all providing their own function to help the bank run smoothly. The major players in FX are (listed in rough order of market share).
These are your major market makers. They provide two ways markets always accessible, in any market condition every second FX markets are open. These banks mainly deal with hedge funds, institutional clients, corporate clients, and retail aggregators.
The rise of electronic trading desks has led to spread compression which is great for everyone not in the business of market making (especially you the retail trader).
Each market maker has their own research that shows them what market appropriate spreads should be for a variety of factors that when all taken into account allow the bank to show out a competitive quote to their clients. Some of these factors include, size of the trade, time of day, current volatility level, future implied volatility, quality of the customer, current market price action, competitor quote levels.
Voice traders are guided by years of experience and intuition in their very specific markets (usually trading only a couple of currency pairs at any given time) while spread quotes given from a bank’s electronic trading desk involve inputs from a suite of algorithms and data feeds.
The end result is a two-way price quote for the client.
How Retail Traders Get Their Price Quotes
The vast majority of traders, by number not volume, are retail traders. Unfortunately access to the source of liquidity and best spreads is not possible for retail traders. Your trading volume is not worth the account maintenance at a bank. More importantly since Forex is an OTC product banks require an ISDA for setting up a trading account.
So as a retail trader you are stuck with going to a broker. Brokers get their quotes from banks add a mark up to the quote and pass it along to you.
Not all spreads are created equal however. A spread from two brokers could be the same but have different last look levels, depth or conditions attached to it.
Last look was an industry practice that got a lot of media attention and in fact a lot of really great research, journal and news articles were written about it. I encourage you to go seek them out. In essence, last look allows your counterparty to either accept or reject your trade based upon a time threshold and a mark to market calculation. More simply, if you’re trading on old rates — your trade gets rejected. In the fast moving world of decentralized trading that is FX, this is essentially a free option for all market makers that their clients provide them with.
Quote depth is the amount of notional a given quote is good for. For example, if you see a .8 pip wide quote in EUR/USD you might only be able to trade 10,000 EUR/USD notional at a retail broker but a bank might be able to show you that same .8 pip spread up to 1,000,000 EUR/USD. The retail broker might be able to show you a depth of up to 1,000,000 EUR/USD at a quoted spread of 2 pips. Depth is a critical component of measuring out what your effective spread is.
Other conditions attached to spreads you see from brokers might include whether they are pass-through or not. Some retail brokers provide you a market quote (with added spread), accept your trade, then immediately offset your trade with the bank (at a reduced spread given to them by the bank) to lock in profits. Other retail brokerages take your trade and hold it internally on their books until the risk is offset by other retail trades going the other way, or at such a time they want to cut the risk.
A lot of the information being written and given out by self-proclaimed ‘FX Experts’ tries to identify unique set ups or some other bizarre pattern. I’m hoping to provide some context and color of what the Forex markets look like from a different perspective. Trading on an institutional level is so vastly different than retail FX it’s hard to capture in these short posts. That’s neither a good nor bad thing as both worlds serve very different functions and need each other. Hopefully you will find these insights enlightening.
Good luck and trade on!
Nothing here should be taken as financial advice, views are the opinion of the writer, please consult your financial advisor on investment strategies suitable for you.