Interbank market
Let`s take a look at how computers help banks trade with each other when they need to close a market position.
The two largest platforms that have automated interbank trading are Electronic Brokerage Services (EBS) and Reuters Matching.
Contents
Both platforms operate on similar principles and their market shares are approximately equal [Gol19]. Historically, some currency pairs trade more on EBS and others on Reuters. Further I will talk about EBS, because most of the euro-dollar transactions take place there.
All transactions on the EBS platform go through the central limit order book (CLOB) or, as Russian-speaking traders say, through the “order book”. Any company can send its limit order using the application or API. To do this, you need to specify three parameters: the direction of the transaction (buy or sell), the size and the desired rate. For example, "buy 1 million at 1.09565 or less" or "sell 1 million at 1.09575 or more." You can also cancel the application or change the size and rate at any time.
EBS server
The EBS server collects orders, orders them according to the desired price (buy orders in descending order, sell orders in ascending order) and sends a summary to all bidders. See details here: forex scalping strategy.
Note that the order book is anonymous. Nobody except EBS and the applicant himself knows who the mysterious stranger is who is ready to sell 2 million euros at 1.09575. It is impossible to even establish whether we see one order for 2 million or two orders for a million from two different market participants.
Market spread
The best buy order at 56.5 and the best sell order at 57.5 form the market spread (also called the best bid / offer, BBO). Unlike a two-way quote from a market maker, these two prices can come from two different counterparties, but this is not essential. To us, it looks like someone gave us a quote of 56.5-57.5 with a 1 pip spread.
For example, to sell 1 million euros, we can send a request “I will sell 1 million at 1.09565 or more”. The system will calculate that our new order can be matched with an existing buyer`s order and will automatically fix the deal between us.
Example
For the opportunity to conclude a deal here and now, we will give the buyer a discount: we will sell euros at 56.5, when the mid-rate is 57.0, that is, a little cheaper. With a deal size of 1 million, this will cost us ⋅ 1,000,000 (1.09565 - 1.09570) = -50 dollars. In the jargon of traders, this is called cross the spread or pay the spread. Strictly speaking, we will pay only half of the full spread of 56.5-57.5, but more often they say “pay the spread”.