Market Microstructure and the Economics of Forex Bid-Ask Spreads

The Truth About What the Spread Means

When you exchange dollars for euros, you are paying a little more than what the market price is in the middle, and when exchanging euros for dollars, you're receiving slightly less than the market price in the middle; the difference between these two prices is called the 'bid-ask spread' and is more than just a transaction cost. It is a real-time measure of how much risk the market is willing to take on and how much uncertainty surrounds the actual value of the asset. It also shows how efficiently products are being priced against one another. In Forex, if there is a lot of liquidity, the bid-ask spreads are closer together, and if the liquidity disappears, the bid-ask spreads will widen. The bid-ask spread can therefore be considered one of the most honest indicators available to economists examining how the market is structured.

When the most liquid conditions exist on the EUR/USD pairs on the primary interbank platforms, we find that the spreads are in the range of 0.5 pips to 1 pip (i.e., fractions of a cent). On the other hand, the USD/TRY currency pairs (US dollar vs. Turkish lira) typically have spreads in excess of 30 pips, indicating the lira is a much more volatile asset and has a much smaller pool of potential counterparties who are willing to take the position of holding it. This is a difference of two orders of magnitude, demonstrating how significantly the liquidity conditions are different for various currency pairs.

The Economic Forces that Influence Spread Variation

Within the framework of the market microstructure theory, we can identify three major sources of increases/decreases in bid-ask spreads: costs of execution of orders (process), costs to hold (inventory), and risk related to adverse selection. The cost to process orders for the most part is relatively small in the current era of electronic transactions. The second risk dynamic is represented by the volatility of the currency pair and how that volatility will increase the minimum spread necessary for the dealer to make a profit while assuming the liquidity risk associated with holding that position. The third risk dynamic, known as adverse selection, is likely to have the greatest negative impact on dealers because dealers will increase their spreads if they believe that the counterparty to their trade has superior information. In other words, if a dealer suspects that the counterparty has superior information and the true price for the currency has rapidly changed, then the dealer will want to protect themselves from being adversely affected and will widen their spread accordingly, as executing a trade against an informed (sophisticated or institutional) trader is likely to be systematically unprofitable.

Widening of Spreads: An Issue for Central Banks and Market Participants

There are potential macroeconomic consequences to widening of spreads related to increasing trading costs for individual traders. As an example, developing countries with poor or little forex trading volume experience widening bid-ask spreads for their currencies and as such struggle to remain competitive in hedging against foreign trade exposure, therefore limiting the amount of investment made in these countries, and creating higher borrowing costs for companies that need to purchase currency protection. The IMF (International Monetary Fund) has documented examples of the transmission mechanism in several countries located in sub-Saharan Africa, where due to the low amount of forex trading volume, there is a greater degree of volatility and greater overall macroeconomic impacts associated with external shocks to the economies of those countries caused by the widening of bid-ask spreads, rather than through price changes alone.

Also, information about changes in the width of bid-ask spreads can act as an early warning signal to central banks and economic policymakers that a country's currency is starting to weaken. If widening of bid-ask spreads occurs rapidly on a nation's sovereign currency (absent a large volatility event), the rapid increase may be showing early indications of a lack of confidence in that nation's economy before the loss of confidence manifests itself completely in the value of the currency as reflected in the market through the exchange rates.