Does the Lack of a Central Exchange Breed Inefficiencies ? : Analyzing the Potential and Problems of Strategies Which Arise From Broker Differences

When we think about the Forex market being an unregulated over-the-counter way of exchanging currencies “on the spot” we often imagine the whole thing as a disadvantage which makes the development of trading strategies difficult as we need a lot of added robustness tests in order to ensure that our strategies are not being curve fitted to a single broker’s data. Although the lack of a central exchange makes the exploitation of inefficiencies hard from a classical perspective it is interesting to remember that the one price rule states that the simple lack of a central exchange will make Forex more inefficient my nature. Through the following paragraphs I will talk a little bit about possible arbitrage opportunities which may arise from the exploitation of the one price rule between Forex brokers and what the obstacles in exploiting them may be.

Since the Forex market lacks a central exchange (meaning brokers can manipulate feeds) and the market involves a very large number of liquidity providers (although the top ten would account for more than 80% of the market’s volume) we could think about each different Forex broker as being a “single market” since its price structure will be unique to its liquidity providers, price smoothing or changing rules and the makeup of the traders that use it to trade. Since the one price rule states that the price of an instrument won’t be the same across all markets we can therefore expect to find exploitable arbitrage opportunities between different Forex brokers.

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The most basic and probably most sound approach I find in this regard is the use of a broker database in which the quotes of many different ECN brokers are compared and trades are entered whenever a broker “falls away” from what the rest of the brokers are agreeing upon. For example if you are collecting data from 10 brokers and suddenly one broker’s EUR/USD code is 5 pips above the rest then we would enter a short trade on that broker to take advantage of that arbitrage opportunity. Using an ECN broker we avoid most of the execution risk – since there are no requotes or slippage – and we can probably get out of the trade with a profit a very large percentage of the time. However we do lose a large chunk of profit due to the added execution costs.

Certainly the above strategy wouldn’t be perfect as sometimes the broker which disagrees could simply be “faster” and other brokers could then agree with it meaning that we would take a loss due to the commission costs we are incurring on each trade. But if we have 10 brokers which agree and 1 broker that is far apart then the high probability is against the broker which is “wrong”.

It is also important to consider that the above strategies cannot be used with brokers who are strict market makers as they will not like this exploitation and they will ban your account for what they consider unfair trading behavior. This is part of most regular Forex broker trading agreements in which you agree not to use this type of trading techniques on their feed since it takes them time to reprocess their feed for their retail customers and therefore you can use “faster” brokers to take advantage of their feed in an “unfair way”. Therefore the above arbitrage technique would be limited to ECN forex brokers.

It is also very hard to judge whether or not the above technique has sufficient trading frequency to be considered a viable alternative since opportunities which justify taking the risk (profit potential above the commissions paid) are bound to be low and possibly extremely time sensitive. In order to trade in this way you would probably need an extremely fast setup in which you can gather quotes, perform analysis and send orders in the amount of time that the offers are at your disposal. You should also be able to close trades as soon as broker equality converges in order to avoid any possible additional execution risk.

It is however clear that arbitrage opportunities do arise from the lack of a central exchange and they can be exploited by retail market participants. Hedge funds and such will not be competing with you as you will be exploiting an arbitrage issue which arises from differences between retail Forex brokers, a place where “large players” do not mingle. Another important thing here is that ECN brokers supposedly also consolidate orders  internally first before doing external processing (meaning that you buy/sell from fellow traders within the same broker) possibly enlarging the potential of the above mentioned arbitrage opportunity.

From the limited research I have done regarding this trading method I would say that about 1 or 2 opportunities come up each day with a profit potential that is usually around 0.5-2 pips. The opportunities regularly converge towards profitable outcomes but in about 5% of cases (I examined only about 50 trade setups) you get an opposite convergence which makes you exit with a small loss. However a much longer term examination is needed to know if there is true potential around this technique or if commissions and opposite convergence will eventually make the strategy lose money.

If you would like to learn more about my work in automated trading and how you too can develop trading strategies with little broker dependency please consider joining Asirikuy.com, a website filled with educational videos, trading systems, development and a sound, honest and transparent approach towards automated trading in general . I hope you enjoyed this article ! :o)

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2 Responses to “Does the Lack of a Central Exchange Breed Inefficiencies ? : Analyzing the Potential and Problems of Strategies Which Arise From Broker Differences”

  1. josh says:

    Wow,
    You always seem to be doing something that I do not expect. Looking into an area that I didn’t see coming. Is this something that Asirikuy might be able to exploit some day? Maybe if a longer term examination proves worthwhile?
    It is great to see the “out of the box” thinking, or maybe my box is not quite large enough yet to recognize that this isn’t yet quite out of the box?

    • admin says:

      Hello Josh,

      Thanks a lot for your comment :o) This is definitely outside our “regular box” in the sense that this article deals with an arbitrage opportunity which differs in nature from the type of inefficiencies we usually attempt to explore. This type of trading cannot be simulated so accurately (we would need multi ECN broker tick data to do this) so the best thing to evaluate the possibilities here would be to run simulations. Even then the best chances of getting profitable results in the long term would most likely be through a PAMM structure of some sort as if multiple Asirikuy members attempted to trade in this way we would effectively “compete” against each other for the scarce opportunities available. We’ll see where this leads in the long term :o) Thanks again for your email,

      Best Regards,

      Daniel

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