Never mind the quality, feel the width
In times gone by, in a market that has long since evolved, there was just one way to tell whether an institution was getting value for money from its forex provider. Luckily for the investor, it was a very simple measure of value, easily observed. This universal metric was, of course, bid–offer spread. Ten years ago, a tight spread meant a good deal, a wide spread meant a bad one, and nothing else counted.
At that time, 10 pips was a reasonable spread to expect to pay in US dollar/Deutschmark, while in the 1970s 20 pips or more would have been normal. These days, just 1 or 2 pips might be charged for a deal in a major currency.
In those good old days, any spread less than the usual was good, and to be pounced on. A forex provider could express appreciation of its client business by narrowing spreads a little, or could push unwanted business away by increasing spreads accordingly.
It was the same in the options market. An option premium was calculated using the Black–Scholes model, and a spread was applied to this to get the final price. By phoning several option desks an investor could easily tell which option was the best value – it just had to be the cheapest. There really was not any problem deciding which provider to plump for.
So what has changed? A recent magazine article quoted a worldwide manufacturer as saying that spreads available to his company were rapidly widening, and that it could no longer rely on market competition to obtain the 1 or 2 pip spreads it wanted. Needless to say, the manufacturer was not pleased, and spoke of a cartel whose object was to manipulate the market. He was partly right, but not in the way he thought.
What has been happening is just the logical extension of market forces. Competition has forced banks systematically to cut spreads to get business … but in the process they have been steadily cutting their own throats. A 1 pip spread in a euro/dollar deal makes about $100 profit per $1m face value deal, if both the bid and the offer are hit simultaneously. However, this is an ideal scenario, and traders are not always able to capture all of the bid–offer spread. With normal market size deals at about $20m, it’s easy to see that the profit available to the trading desk is just a fraction of what it was.
So, there is a point – and it has arrived – where forex providers just don’t want the business at the spreads extant in the market. Market forces pushed the spreads down … and market forces are pushing them back up again. Of course, they are never going to get back to 20 pips. But they are now at the level where it sometimes hurts the forex provider to provide the deal – especially when issues like credit cost and overheads are taken into consideration. Trading floors have shed a lot of their forex capacity in the past year or two, responding to the fact that it just isn’t as profitable as it used to be. So if there is a cartel, it is a totally unconscious one, and none of the members are in touch with each other.
Moreover, there is a good argument that spread widening is a natural consequence of changing market practice. As the forex market moves more towards electronic media, interbank trading, which used to make up the bulk of deals done, has declined. It’s now possible to do by computer what previously needed an interbank team. However, this has an interesting consequence. These systems are generally order-based, with only one side of a deal being quoted or requested. Thus to a certain extent, the ‘spreads’ observed on these screens are just functions of the number of quotes – ie, the market liquidity. And as forex providers contract and shed staff, liquidity declines. And as liquidity declines, the spreads increase…
The investor who needs to do forex business today is in a very different position from his counterpart 20 years ago. He can call five different banks to get a quote on a vanilla deal or an option structure, and unless the structure is very complex, he will obtain pretty much the same price from all of them. What should he do? How can he be sure that there is not, indeed, a cartel operating against him?
The answer lies in the other services that the forex provider can offer. Spreads and other direct costs are unlikely to go any lower, and are unlikely to differ widely between institutions. However, there is a vast difference in the type of services available to clients under the label ‘value-added’. This is the region where different providers can differentiate themselves and show how much they really want a customer’s business. A good forex house will, these days, enter into a symbiotic relationship with a customer, whereby the spreads that it charges will be sufficient to make a profit, and the services it provides to the customer will be well worth the spreads. There are a number of different relationships now existing within the markets where banks charge customers spreads that are larger than they might get elsewhere, but the customer is receiving services that are valuable enough to more than recompense them. What kind of services are we talking about?
Broadly, they fall into the categories below. Essentially, the forex provider is offering the customer the benefit of its years of experience trading the markets:
q trading advice;
q analytical services;
q hedging advice; and
q alternative delivery methods.
Trading advice can be valuable to a company that does not have the resources to watch the markets 24 hours a day. It can range from an estimate of liquidity at a certain time of day to advice on trading strategies. Having access to a room full of experienced traders can be a real boon to a company without its own substantial FX presence. Even if a company is an experienced FX player, the alternative approaches used by a separate institution can provide valuable diversification benefits.
Analytical services are available because there is often a wealth of quantitative expertise available from research and structuring groups. A CFO might wonder how a particular option strategy would perform – for example, hedging an FX exposure with options on a rolling monthly basis, versus the same strategy with forwards. An analytical group could simulate the performance of both strategies over the past 10 years, giving the CFO some sound statistical analysis on which to base his decision. Otherwise, to get the same project completed, he would have to call in an outside consultancy. Such services might be provided as part of a good dealing relationship.
Hedging advice can include strategy simulation, accounting advice and structuring. Many forex providers are very experienced in the accounting issues which their clients may be encountering for the first time. They may also have products designed specifically to address some of these accounting problems.
Alternative delivery methods could include new technologies like the internet. A number of forex providers are joining forces to provide dealing access via the web, and a number of companies are creating their own platforms for forex input. Close co-operation between provider and user in this environment can be extremely useful to both.
So, the answer to the question ‘how do I get value from my forex provider?’ depends upon the kind of value that you want. If spreads are the name of the game, then the best thing to do is to call up four different banks and take the tightest. In today’s market, you will be sure to get a very tight price. However, if your measure of value is broader and includes the in-depth advice and services that an experienced trading floor can provide, then it may well be that spreads are not the most important measure of the value of a deal.
Jessica James is head of strategic risk management advisory at Bank One in London