Have you ever wondered why exchanging currencies has become cheaper and faster over the years? This reduction was possible by introducing tighter spreads. Spreads are one of the most important concepts in financial trading, especially for short-term trading strategies. They are the cost of doing business and allow brokers to generate revenue from traders by offering access to financial markets. As technologies advance and access to financial markets becomes more available across the globe, trading costs experience reduction. Let’s analyze spreads and how they are affected by technologies over time and define if they got tighter over the years.
Understanding Currency Spreads
The spread definition in trading is critical to understand as it defines financial trading costs and can mean the difference between making and losing money. There are many types of spreads including bid/ask spreads, yield spreads, Option adjusted spreads, and more. However, we are going to focus on the standard bid/ask spread, as it is the most well-known and critical one. Spreads are crucial for traders as they have to pay these fees twice, once when they open the position and the second time when they close it. In more simple terms, spreads are the difference between the bid and ask prices. Bid and ask prices are the prices traders see on their platforms, in which they can buy and sell currencies or other assets. Typically, assets are given in bid and ask prices where traders can click on buy or sell and these two prices are always different as traders typically pay more when they buy when compared to the immediate selling price. For example, if the bid price for EURUSD is 1.2000 and the ask price is 1.2003, the spread is 3 pips (0.00003). The size of the spread depends on market conditions, currency pairs, and brokers.
The Historical Landscape
In the early days of FX trading, spreads were very large due to several factors. The Forex market was less liquid as there were fewer participants, and transactions were often conducted over the phone and manually. The international banks and hedge funds were not as popular, and there was low demand for Forex trading from retail traders. Technologies and the internet were also significant factors in lowering accessibility to financial markets. This lack of efficiency, which is a character of a less liquid market, led to significantly higher costs for traders. The markets were dominated by large financial institutions, which had more pricing power and could maintain wider spreads. After electronic trading was introduced in the late 1990s, the trading landscape began to change radically. This novel way of trading meant more participants could access markets, increasing liquidity and competition. Brokers could offer lower spreads as the cost of executing trades decreased, which benefited both retail traders and institutional investors. As a result, spreads started to get cheaper and allowed traders to develop new strategies which previously were unprofitable.
Spreads and Technological Advancements in Forex Trading
As you would already guess, technological advancements were the main reason why spreads and trading costs started to decrease over the years. From major developments that contributed to this phenomenon, a few are noteworthy:
Online trading platforms
The introduction of online trading platforms which allowed traders to access financial exchanges from their homes revolutionized the Forex market. Traders could now execute trades instantly and access real-time data, narrowing spreads even further. The need for a phone call or physical trading was gone and everything became electronic.
High-Frequency Trading (HFT)
High-frequency trading algorithms execute large amounts of orders at extremely high speeds, which is impossible for human traders. HFT firms provide liquidity to the market, which helps to further reduce spreads. Sophisticated HFT algorithms can identify arbitrage opportunities and correct price discrepancies quickly, which tightens spreads in financial markets.
Algorithmic Trading
Beyond HFT, other algorithms have become popular. These algorithms can analyze vast amounts of data and make highly accurate trading decisions, improving market efficiency and reducing spreads.
Increased competition
The rise of online brokers and advanced trading platforms increased competition in the financial trading industry. Higher competition led to further reductions in spreads and trading costs as brokers tried to retain their clients.
Enhanced Market Transparency
Technological advancements increased market transparency as traders have access to a wealth of information and tools, allowing them to make more informed decisions. This was also simplified by regulatory developments which left less room for scams and fraud, promoting more healthy financial markets.
