Margin

Banks’ e-commerce pricing engines source their rates from EBS and Reuters 3000 Spot Matching (D2), both via by Reuters on TIB or Triarch infrastructures. However, the banks do not let most customers trade at interbank rates. This is because banks add or subtract a margin to their rates in order to generate additional profit and to reflect the creditworthiness of the client. Margins vary hugely from customer to customer. The best customers may be given a total spread of only 2 pips in EUR/USD compared to an interbank spread of 1 pip. The least sophisticated customers may be spread many big figures, known by FX traders as “Thomas Cook” rates. Spreads have tightened significantly since the advent of e-commerce trading systems, which have allowed the banks to be more competitive through cost savings. There are three ways of applying margin per currency pair in an e-commerce trading system:

• Minimum spread - the customer will experience a fixed number of pips between the bid and offer, regardless of the trader’s spread. This fixed spread may be configured to be at least as wide as the trader’s spread in order to prevent negative margin.
• Fixed margin - margin will be applied at a fixed number of pips either side of the trader’s bid and offer.
• Multiplied spread - the customer will experience a spread that is a fixed multiple of the width of the trader’s spread.

Market-savvy customers are normally quoted a two-sided (or “two-way”) price by banks. This means that the customer sees both the bid and the offer price, regardless of which way the customer intends to trade. This makes the spread very transparent to the customer, and many customers therefore expect to be quoted prices in this way.

It is common for sales desks and e-commerce systems to quote one-sided (or “one-way”) prices to less sophisticated customers, as this hides the size of the margin or spread from the customer. In this way, customers must state whether they wish to buy or sell before they ask for a price.

Automatic and manual pricing

When a customer asks a bank for a price via an e-commerce trading system, the bank will price the trade in one of two ways:

• Automatically - using rates from the bank’s pricing engine
• Manually - where trading or sales enter a price to be sent back to the customer (dealer intervention). Typically a rate from the bank’s pricing engine will be pre-populated into the manual pricing tool in order to save input time. In this way, the price is edited rather than being entered from scratch.

The choice of pricing method is made by the e-commerce system based on the following factors:

• Amount of the trade - because of the higher risk, trades above a certain amount cannot be priced automatically.
• Currency or currency pair - this affects the amount threshold. Some currencies or currency pairs are more liquid than others. For example, EUR/USD would have a much higher amount threshold than EUR/CZK. Some banks configure this by currency and others by currency pair. Configuring by currency is more dynamic and flexible because the system can then use the lower threshold of the two currencies in a pair.
• Trading channel - customers trading via e-commerce networks (ECNs) such as FXall and Currenex are usually seeking prices from multiple banks simultaneously and it is important to give a price as quickly as possible via these channels.
• Customer - some banks configure their best customers to get an automatic price up to a higher amount threshold because the bank can provide a faster price automatically than it can manually and they trust the customer not to abuse it.

When a price is provided automatically from a bank’s pricing engine, it will have a time-to-live (in seconds), beyond which the customer may not hit the price. Some banks offer streaming prices, whereby the price is automatically updated with a new price before the previous price expires. Most banks’ e-commerce systems also impose a time-to-live on manual prices, but may also allow trading or sales to update a manual price.

Generally, automatic prices from a pricing engine have margin added automatically before reaching the customer. In the case of manual prices, this varies by bank in that the manually entered price may be required to include margin. Likewise, some banks use traders to give manual prices, and other banks use sales (who in turn need to obtain a price from a trader). Where sales give a manual price, margin is usually included in the manual price so that further margin need not be applied by the e-commerce system.

Retail vs Wholesale Spreads

A common question is why spreads in the wholesale market increase with transaction size, whereas spreads in the retail market decrease with transaction size. The cost of a transaction is generally not affected signficantly by the size of the transaction. Typically, the amount of manpower and processing costs are the same, regardless of transaction size. Therefore, with small retail transactions, the cost per transaction is very high in proportion to the size of the transaction, and so wide spreads pay for such costs. In addition, any transaction involving banknotes increases costs further because cash is expensive to handle and transport. In the wholesale market, the cost per transaction is very small in proportion to the transaction size, as the traded amounts are much higher. However, as transaction size increases in the wholesale market, the market risk for the price-making bank increases, as it is more difficult for the bank to exit the position created by the customer's trade. Wider spreads for large trades protect price makers by giving the bank more time to exit a position before the market moves against the bank's position. The following graph illustrates the relationship between transaction size and spread in both the retail and wholesale markets:



The dividing line between the retail and wholesale market varies and is dependent on many factors, for example the type of price maker, the type of customer and the method of settlement (cash, bank transfer, credit card, margin trading). In practice, established customers in the wholesale markets enjoy wholesale spreads even on very small amounts. In some cases, wholesale spreads are available to retail customers for very small amounts, e.g. spending on certain credit cards.