What Is Reduced Spread?
- A reduced spread is the narrowing of the difference between the bid and ask price for a security, currency, or loan.
- This spread reduction is a decrease in the difference between what buyers are willing to pay and what sellers are asking.
- The reduced spread generally translates to a decrease in potential revenue that is generated from the bid/ask spread for brokers and dealers that make a market for that security.
Understanding Reduced Spread
The reduced spread generally translates to a decrease in potential revenue that is generated from the bid/ask spread for brokers and dealers that make a market for that security. This spread reduction is a decrease in the difference between what buyers are willing to pay and what sellers are asking. In most cases, a reduction in the spread signifies that a financial institution will experience a decline in its profit margin that comes from the spread.
Forex dealers and brokers, as well as those in other marketplaces, will usually earn their commission on the spread of bid and ask prices. Brokers work for individuals by placing trades for stocks, bonds, currency, futures, and other investments. Dealers, on the other hand, will usually arrange trades for themselves or large institutional clients. Brokerage fees will vary by the product traded and the company trading those products.
However, depending on the situation, there may be a way for brokers and dealers to offset some of this profit decline. As an example, the broker could minimize operating costs. Forex brokers and lending institutions can use a carefully planned, long-term strategy to offset reduced spreads. Such an approach will include selling Treasury bond futures contracts because there is an inverse relationship between bond prices and interest rates, meaning as interest rates fall, bond prices rise, and vice versa.
Causes of Reduced Spread in Different Markets
The basic concept of reduced spread, in general, is the same in any context, but there are some specific ways it manifests itself in the real world depending on the financial instrument or situation involved.
- For lending institutions, a reduced spread in a loan rate translates into a reduction between the cost of lender-available funds and the interest rate at which these funds are lent out. Factors that impact the spread of lenders include competition from other creditors, less perceived risk in the lending market due to favorable economic conditions, and increased liquidity in the secondary market for these loans.
- In the foreign exchange market, a reduced spread will lower the difference between the currency's purchase price and the asking price. This price difference can be due to an increase in expected volume for the particular currency. Bid-ask spreads contribute to the inefficiencies of matching currency buyers with sellers.
- For the equity market, the reduced spread is a reduction in the gap between the price that a market maker is willing to transact in a deal for a stock, if there are no other counterparties for an order. This reduction is done to ensure liquidity in the trading market, and to allow the generation of additional profit.
The spread goals of registered traders will vary by company. Much depends on the trading activity, issuer size, and public float. In investing situations, the inability to predict the likelihood of a reduced spread happening, or the degree and frequency to which they occur, is another element that contributes to the level of uncertainty, particularly in long-term investment plans.