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Stocks & Commodities V. 30:1 (30-34): A Guide To Forex Arbitrage by Joseph James Gelet & EES Research Team

FX versus
other markets
Forex markets are not traded
on an exchange; forex is an
over-the-counter (OTC) spot
market where participants
exchange one currency for
another. Since there is no
exchange, the price that one
bank may quote for an FX rate
may be different from that of
another bank.
However, with technologi-
cal developments such as the
increase of Internet speeds,
computing power, and pric-
ing algorithms, FX prices can
be obtained from multiple
sources. Further, since banks
also trade with multiple coun-
terparties, a close to market
price can be created. This
means the difference in price
between different FX liquid-
ity pools could be minimal.
Price discrepancies may only
exist for a minuscule length
of time (in fact, measured
in milliseconds), and it is
questionable whether these
discrepancies provide ample
opportunity for profit.

Banks and
arbitrage

ROBERT CRAWFORD
If there were a way to profit
in the FX markets with little
risk, why wouldn’t the banks
be taking advantage of it?
The Risks, The Pitfalls, The Intrigue The answer is more complex

A Guide To Forex Arbitrage

than it seems, because banks
create the FX price and the
algorithms involved in the
price creation take numerous
variables into consideration.
In addition, banks typically
What should traders understand about arbitrage as it pertains to the forex market? attempt to make markets and
do not normally engage in
by Joseph James Gelet, EES Research Team proprietary FX trading on

F
behalf of the bank. So their
oreign exchange arbitrage is a hotly debated topic in the forex community with many role is usually that of find-
unknowns, as successful arbitrageurs may not have the incentives to disclose their meth- ing the best price for their
odology until after it is no longer effective. Since the concept of arbitrage is so intriguing, clients and profiting by either
traders are attracted to it but do not have resources to find quality unbiased information on charging a commission or a
the subject. We will discuss some of the most important aspects that traders should understand spread markup.
about arbitrage as it pertains to the FX market. Banks have many ways to
Copyright © Technical Analysis Inc.
Stocks & Commodities V. 30:1 (30-34): A Guide To Forex Arbitrage by Joseph James Gelet & EES Research Team

profit from FX without needing to quotes to other banks, a process

utilize arbitrage. For example, retail known as “price discovery,” which
exchange rates offered to smaller can happen in seconds. Previously,
clients may have a spread of up to 1.3862 this may have involved a bank
1% of the total transaction or more, 1.3864 trader calling several banks to get
JP Morgan 1.3868
which is pure profit for the bank. information about the offered or
RBS
Generally, customers such as trav- 1.386433 bid rate. Price discovery is usually
elers exchanging small amounts of 1.3863 done by sending bids and offers at
money don’t mind paying such costs different price levels to see if there
(but then, they don’t have much 1.3866 are any takers. If there are none, the
choice!). Banks don’t profit a lot on bank may have to buy at market
each deal, but due to the large amount rates already bid and offered.
1.3864
of volume of small transactions, this UBS In this example you can see
can add up to a good profit. the price between two individual
Since they have a near monopoly banks, Royal Bank of Scotland
on this activity, they may not see FIGURE 1: FX PRICE CREATION. The price between two individual (RBS) and Union Bank of Switzer-
a need for investment in highly banks, RBS and UBS, is 1.3866, which is different from the price land (UBS), is 1.3866. This differs
sophisticated arbitrage trading that
between UBS and JP Morgan — 1.3863 — and different from the
price between JP Morgan and RBS 1.3864. The number in the
from the price between UBS and JP
has its own unique set of risks. These middle of the diagram where all three circles intersect would be Morgan, which is 1.3863. It is also
transactions are one way that banks known as the market price. different from the price between JP
profit in the FX market, but it pro- Morgan and RBS, which is 1.3864.
vides a good example why banks are not anxious to develop The number in the middle of the Venn diagram where all three
proprietary arbitrage trading models. circles intersect would be the market price. As you add more
Another factor to be considered is volume, which is typically banks to the diagram, the price would change.
opaque to the average customer. If a bank has an order to sell The example uses a simple average between two prices
100 million EUR/USD or more, it may not be available at the to negotiate on a tradable price, and the market price is the
current price. They may have to sell EUR/USD to multiple average of three interbank prices. Actual pricing algorithms
counterparties, each at a different price, providing their client are significantly more complicated, and we have not even
with an average fill price. considered volume or the spread.
By obtaining the best possible price for their client, they can However, it does illustrate how a forex price is created. The
charge a commission or possibly mark up the price by one pip major difference between forex and other markets is that on
while still providing an excellent price to the client on a large an exchange you can only have one price with two types of
order. If in this “price discovery,” a bank found an off-market players (buyers and sellers), whereas in FX you have multiple
price that would be considered arbitrage, they may take it but exchanges known as an electronic communication network
pass it to their client mixed with the other trades included in (ECN) or a liquidity pool. To complicate matters, individual
the average fill price. (We’ll discuss price discovery in a few banks may participate in multiple ECNs. So it is not always
paragraphs.) easy to determine which parties are responsible for a particular
This would be considered a wholesale price in other indus- price creation.
tries; companies may purchase products from manufacturers The result of this multinode network is a smoothed price
and mark up the price for a small profit. It isn’t much different that is considered the market price globally. If any bank offered
here, except it is done in real-time and calculated by use of a significantly off-market price, traders or other banks could
pricing algorithms. So while banks do not necessarily engage easily take advantage of it and have an arbitrage opportunity.
in proprietary arbitrage, they have an incentive to constantly Bear in mind this is all happening within seconds, so without
find the best forex price for their clients. the use of advanced computing technology, it would be dif-
ficult to follow this activity.
How a forex price is created
Banks have millions of clients who want to exchange cur- Buy side versus sell side
rencies, known as “deliverables” (for example, you want to In equities, the sell side represents an investment bank that
send funds from Europe to the US, whereby Deutsche Bank issues a security and sells it to the market, and the buy side
may exchange your euros for US dollars at JP Morgan). Since represents other investment banks and investors who buy the
banks have such a large demand for FX known as “real money security in the market from those banks.
flows,” they need to actively trade forex in order to exchange Foreign exchange is a little different, but a similar rela-
these funds on behalf of their customers. tionship exists. In forex, the terms “buy side” and “sell side”
Figure 1 shows how a forex price is created. Banks have are not as appropriate as it is in equities. A better description
customers who want to trade their euros for dollars and vice would be “liquidity maker” and “liquidity taker” — the maker
versa (EUR/USD is used in this example). Each bank then sends being the banks, and the taker being traders or other banks.

Copyright © Technical Analysis Inc.

 Stocks & Commodities V. 30:1 (30-34): A Guide To Forex Arbitrage by Joseph James Gelet & EES Research Team
FOREX FOCUS

FX convolutes this even structure that is constantly

more. Sometimes these play- EUR/USD 1.28 1.28 v1.280385 EUR/USD 1.28 1.28 v1.281590
being updated.
ers will reverse roles, or they
may be a maker on one ECN 7.4 1 36 3 15 1 46
Practical 36
and a taker on another. As Sell 1m
BID
Sell 2m Buy 1m Buy 2m Sell 1m Sell 2m Buy 1m Buy 2m
examples
there is no standard for how
EUR OFFER BID EUR OFFER
The image of Figure 2 was
to manage FX order flow, Figure 2: making a profit from price difference. If you send a buy and taken on the Currenex in-
banks and other institutions sell order at the same time, you could capture the price difference and make a profit. terbank platform during a
This would only work if you had an automated system.
can become creative and have release of nonfarm payrolls.
the ability to structure their order book in many ways. And If a trader was quick, it would be possible to click buy and
because this structure is internal and confidential, we can only sell and capture the difference in profit because the bid is
speculate based on output (which we see in the markets and in higher than the ask. Unless you clicked both buy and sell at
public data such as Bank for International Settlements [BIS] the same time, which would be impossible if you were trading
surveys and volume reports). manually, your risk would be that price would change by the
time you clicked the other side. It is possible for the price to
Viability of arbitrage in forex change in one second.
Developing any type of arbitrage trading
chnical Analysis of STOCKS & COMMODITIES magazine strategy requires the If you use an automated system, it would be possible to
following elements: send a buy and sell order at the same time and capture the
price difference. This strategy is near flawless but would have
ren Moore with approval
n Access to theor changes:
highest quality price information
a limit defined by the amount of volume available at that price.
n Fast Internet connection at multiple nodes
This opportunity may only happen a few times a month.
n Sophisticated computer
0570 • fax: 206-938-1307 • email: hardware
KMoore@Traders.com
n Custom software written to execute the strategy Latency restrictions
n Constant updates of the infrastructure Given that markets are interconnected globally through the
Internet, latency should be considered when developing any
This requires a solidPROOF
understanding #1 of the involved technolo- type of arbitrage strategy. Arbitrage opportunities may last for
gies, but fulfilling these requirements does not guarantee you a only a few seconds, if that. If the latency to your counterparty
profit, either. You could also build up a specific infrastructure is 100 milliseconds, and it takes 200 milliseconds to fill an
that will take time to create, and by the time you can imple- order, the market may have changed during that time, in which
ment it, the types of existing opportunities may change. case the trade could end up being a loss. Slippage should also
But how practical is it? While we don’t have information be considered. Unless the opportunity has a large spread, a
about how many arbitrage traders there are, we can assume small amount of slippage could turn a seemingly profitable
that at least several well-funded and sophisticated groups are arbitrage opportunity into a loss.
trying to take advantage of such opportunities in forex. Not Latency is volatile and should be monitored in real-time.
only would you be competing with them, as the market and Numerous Internet service providers (ISPs) are involved with
technology evolve, you would be also competing with infra- a number of routers and network connections. Just because
the current ping to your counterparty is 20 milliseconds (ms),
that doesn’t mean it will always be 20ms. During a large
market event, depending on the bandwidth of their network
infrastructure, a large amount of price data could create ad-
ditional delays. Any arbitrage strategy should incorporate
Advanced algorithms deliver real-time network monitoring as part of the strategy.
low lag, low noise analysis.
Fill risk
Another risk in arbitrage strategies is that orders may not be
filled quickly, if at all. If you needed to use more than one
Now featuring counterparty, there is a chance that one of them may reject
Tools for... your order. In this case, you would have a naked real posi-
tion in the market that would be subject to traditional profit
and loss. If leverage was used, this could be a big risk if the
Also for: AmiBroker, Wealth-Lab, MetaTrader, Wavewi$e, Excel, Investor/RT, BioComp Profit, NeoTicker,
market was moving quickly.
Tradecision, TradingSolutions, MATLAB, TradeStation, Ninja Trader, eSignal, NeuroShell Trader, Financial
Data Calculator, Genesis TradeNavigator and TradersStudio.
Counterparty risk
www.jurikres.com • 800-810-3646 • 719-686-0074 Any arbitrage strategy requires at least one counterparty to
trade with. In the case of multileg arbitrage, it may require more
For more information circle No. 10
than one. Quality of the counterparty should be considered.
Copyright © Technical Analysis Inc.
 Stocks & Commodities V. 30:1 (30-34): A Guide To Forex Arbitrage by Joseph James Gelet & EES Research Team
FOREX FOCUS

forex correlations are interesting because

While arbitrge is alluring, Example 1 Example 2
of the connections between other markets
traders should consider A B A B and money markets, which sometimes rep‑
risks and pitfalls 2 2 9 2 resent real money flows from one market to
associated with trading. another. Some correlations that have been
3 3 8 3 noted by traders are:
There may exist an inverse correlation 4 4 7 4 n Pair correlations (that is, a move in
with the quality of the counterparty and 5 5 5 5 GBP/JPY is correlated with GBP/
arbitrage opportunities. For example, a USD and USD/JPY)
big-name forex bank such as JP Morgan 1 -0.98270763
n Stock markets correlated with
likely has a lot of experience, and even FIGURE 3: CORRELATIONS. The correlation
certain forex pairs, such as USD/
their personnel may have some experience between datasets A and B in example 1 are
JPY being correlated with US stock
with forex arbitrage. They probably have a identical so the correlation value is 1. In example
2, datasets are almost opposite, so correlation markets
sophisticated infrastructure, if only because is almost ‑1. Trading a correlation strategy may
of their large budget. Finally, due to the be a more appropriate strategy for you to use as n Correlation between certain com‑
large amount of liquidity they process, any opposed to arbitrage. modities, especially oil, and the
arbitrage opportunities may be smoothed US dollar.
by their liquidity algorithms.
In contrast, a small underfunded forex brokerage with a Correlations can be calculated using Microsoft Excel, with any
small amount of experience and bare-bones infrastructure may two sets of data (=CORREL). Usually, traders use daily data to
provide many opportunities for arbitrage, but these opportuni‑ calculate correlations, but any two datasets can be used. The result
ties come with risks: will be a correlation coefficient (a number from ‑1 to +1) 1 being
100% correlated and ‑1 being 100% negatively correlated.
n Failure to fill one leg of the trade
In example 1 (as seen in Figure 3), datasets A and B are
due to technical difficulties
identical, so the correlation value is 1. In example 2, datasets
n They can reverse your trades are almost opposite, so correlation is almost ‑1. Traders without
significant experience or capital/time investment may want to
n They can go out of business.
consider trading a correlation strategy as opposed to arbitrage.
Differences between
arbitrage and correlation
Conclusion
While price discrepancies have been
Many arbitrage strategies are actually correlations. Traders
documented in forex, capturing them
believe in their mean-reversion correlations so much that they
may require a large investment in
consider them to be arbitrage when actually they are correlations.
time and money and experience in
That is not to say they are not effective, just that it is not fair to
programming and trading. While
call them arbitrage. Traders seek correlations in all markets, but
arbitrage is alluring, traders should
consider the risks and pitfalls associ‑
ated with this type of trading.

Joseph James Gelet is the president

of Elite E Services, which develops
automated forex trading systems and
offers managed accounts. Reach him
at http://eliteeservices.net.

Suggested reading
• http://en.wikipedia.org/wiki/Foreign_exchange_
market
• http://en.wikipedia.org/wiki/Millisecond
• http://en.wikipedia.org/wiki/Electronic_communica‑
tion_network
• http://www.bis.org/publ/rpfx10.htm
• http://eliteforexblog.com
“Schedule A, line 16G: Do you wish to make a charitable
donation to help pay off the national debt?”

Copyright © Technical Analysis Inc.

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