Credit risk and market segmentation
A computerized order book market looks promising. All market participants can send their orders, not just selected market makers.
It can be expected that competition between sellers will lower prices in bids, and competition between buyers will increase prices in bids. As a result, the market spread, at least for small trades, will be narrower, and many companies will find it more profitable to transact through EBS rather than through market makers. Unfortunately, it’s not that simple.
Contents
EBS and Reuters operate on the broker model, that is, intermediaries. When the EBS system brings together buyer and seller orders, such as Deutsche and JPMorgan, there is a two-way deal between these companies. The role of the company (ref.: https://nsbroker.com/investment-strategies/simple-forex-scalping-trading-strategy) that owns the trading platform is similar to that of a realtor: help the buyer and seller find each other, charge them a small commission for the service, but in no case become a party to the contract. In the language of economists, credit risk is borne by the seller and the buyer.
What is the credit risk? Suppose, as in the example above, we bought 10 million on EBS at an average price of 57.63. For the sake of simplicity, let`s assume all 10 are purchased from the same vendor. We expect that on the second working day we will receive 10 million euros from this seller and immediately transfer it to client. The client will pay us $ 10,958,000, and the EBS seller will pay $ 10,957,630. In total, our payments in euros will collapse to zero, and we will have $ 370 in profit.
If the seller goes bust
If the EBS seller goes bust, we`ll be in trouble. We still need € 10 million, which will have to be bought from the market at the new market rate. It is good if the market rate has not changed much or decreased. If the market rate has grown strongly, then we will have to buy the euro at more than 1.0958 and fix the loss. It would seem that we did everything right, almost securing a profit for ourselves, but the unexpected default of the seller left us in the red.
Credit risk
As you can see, credit risk is no joke. Before the two companies start trading with each other, they will have to sign a bilateral agreement, assess each other`s creditworthiness, agree on collateral and set limits if necessary (“do not trade with company X more than a billion”) and report all this to EBS. The system will never converge the seller`s bid with the buyer`s bid if the seller and the buyer have not gone through all this bureaucracy. This has a funny consequence: different EBS clients can at the same time see a different state of the order book, depending on which of the senders of limit orders they can trade with and with whom they cannot.