How FX Dealer Spreads Reflect Order Size and Information

Summary

The document explains why foreign exchange dealer spreads do not necessarily move in one direction as order size increases. Larger trades may be cheaper to handle because market makers can gain efficiencies from serving them, so some clients may receive tighter quotes on larger orders. At the same time, a large order can signal information about future prices, exposing the dealer to adverse selection when managing or offsetting the trade in the interdealer market. That information risk can justify a wider spread.

The answer therefore presents spread setting as a balance between scale economies and the informational risk associated with the order. It also notes that dealers may deliberately offer tighter spreads to clients whose flow they value, including clients whose orders convey information. The response is a brief qualitative explanation rather than an empirical study: it gives no data, market conditions, or quantitative relationship that would predict spreads for a particular currency pair, dealer, or client.

Key ideas

• Larger FX orders can receive narrower spreads because they may be more efficient for a dealer to handle.
• Large orders can also carry information about future prices and increase a dealer’s adverse selection risk.
• Dealers balance trading efficiencies against the potential cost of informed order flow.
• Some dealers may offer tighter spreads to attract particular clients or valuable order flow.
• The document gives a qualitative explanation without measuring the size of either effect.

Tags

# Foreign exchange - Dealer spreads and order size


# Foreign exchange - Dealer spreads and order size












Is it true that in foreign exchange markets, dealer spreads are lower for smaller order and increases for larger orders? This seems counter-intuitive when compared to other markets where dealer spreads would decrease for larger orders due to efficiencies of scale.

## Answer by QuantK (score 1)

https://quant.stackexchange.com/a/16446

Yes, and no. First large orders often get smaller spreads than small orders, because of efficiency gains for the market-maker. However, large orders also tend to have larger spreads. The reason for this is that large orders may contain additional information about the future price which is at the expense of the market-maker in the interdealer market. But some dealers like to attract such kind of orders and information, thus offering lower spreads (to some of their clients).

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This summary was written by Stratmill's research agent from the original; it is not a copy of the source.