What is the Spot Market?

What is the spot market?

What is the spot market?

 

What is the spot market? The term “spot market” is a common term. It denotes a buying and selling market, typically for commodities, currencies, and for other financial instruments, where the assets are purchased or traded for delivery “on the spot”. The immediacy may requires a few days in some cases for title to actually pass or for “good funds” to be received at their final destination once the transaction has been actually consummated.

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Another convention of the spot market also called the “cash market” or the “physical market”, is that settlement is usually set as “T+2”, a requirement that cash be delivered within 48 hours. If the transaction is not for immediate delivery on the spot, then the market is typically a derivatives market, which deals with futures, forwards, swaps, and options contracts. Transactions in both cases will usually take place on an exchange or over the counter (OTC).

How is a Spot Price Determined?

Spot markets operate based on one single premise – buyers and sellers must agree to a price on the spot. While actual settlement might take longer, the agreement on price drives subsequent actions. The forum for these price agreements is typically an electronic exchange where buyers and sellers post orders at a specific price, which generally are filled quickly before new orders arrive. A more informal process where buyers and sellers deal directly with one another is called over the counter.

When new orders flow into the exchange, the spot price changes. Depending on the market, there are as many as ten or more variables that can impact price from interest rates and inflation to political pronouncements or the weather. Speculators make up a portion of these trades, and this volume actually helps to tighten spreads and reduce variances between exchanges.

Spot Market Exchanges and Over-the-Counter

Financial markets by their very nature are complex entities, but they play a critical role in what traders refer to as the price discovery process. There are two ways that these markets have been organized for efficiency. They are either an exchange, a centralized hub for exchanging information, or they are over the counter (OTC), a decentralized approach where buyers deal directly with sellers.

While most exchanges began as physical locations for their communication exchanges to occur, the advent of electronic trading platforms has eliminated the need for face-to-face trading floors. OTC markets on the other hand are less formal and have never been centralized. The foreign exchange market, as large as it is, is actually an OTC market. Dealers and market makers exist in each venue, but in an exchange, the prices are centralized for all market participants to see, and executed price points are shared afterwards.

 

Spot Market Examples

The birth of spot market exchanges is often attributed to commodities, where corn, coffee, oil, pork bellies, soybeans, and a host of other items were bought and sold on the spot. The best known of these are the Chicago Mercantile Exchange, the Chicago Board of Trade, and the New York Mercantile Exchange, all members of the CME Group. The world of foreign exchange, however, has the largest volume turnover on a daily basis, nearly $6.6 trillion based on the 2019 triennial survey of the Bank for International Settlements (BIS).

The forex market is an OTC market and consists of two tiers. There is no central exchange where buyers and sellers congregate. Global banking institutions, insurance companies, hedge funds, governments, corporations, pension funds, and large financial institutions populate the first and foremost tier. The trading between these major players is often referred to as the “Interbank Market”, and forex brokers often refer to these participants as liquidity providers. Ten large banks control a substantial portion of the trades in this top tier.

Of the $6.6 trillion daily volume, roughly $2 trillion of that volume figure consists of spot transactions. The second tier consists of brokers and domestic financial institutions. The first tier entails wholesale pricing, while the second tier is more attuned to retail. Retail forex traders may be found in this niche, but their total volume makes up only a small portion of the total daily turnover. Size does matter in this environment. Brokers may be a trader’s online market maker, but the broker’s relationships with large liquidity providers will necessarily be priced based on the broker’s volume throughput.

Lastly, when you go to a bank to wire funds overseas, you are literally buying the destination currency at the spot for delivery in two days. Your bank will add additional fees to the process and post a spread that differs from an Interbank rate, but intermediaries are in the business to make a profit. A little known fact about forex trading is that brokers close out existing trades at night, charge a rollover fee, and then re-open the transaction for the next day’s trading activity. This process prevents the actual delivery of the currency and permits traders to speculate without delivery concerns. Day traders close out trades each day, thereby avoiding rollover fees.

The Pros and Cons of the Spot Market

Spot markets are an important mechanism for setting real-time prices for a tradable asset. These prices are actually the first building block when determining a price for a forward, an option, a future or a swap instrument. Since the spot market activity tends to be large in a given arena, it also provides a high degree of liquidity due to its elevated presence.

Spot prices, however, are not suitable for hedging. Options and other derivatives have evolved over time to provide corporate treasurers, bankers, manufacturers, farmers, and any other participants involved in the flow of commodities or currencies an effective way to lock in prices and the cost of production, while giving suppliers the ability to lock in margins. Constant vigilance may be required to prevent those scenarios where the physical delivery of the asset could occur.

 

Concluding Remarks

Spot markets are an integral part in the process for exchanging value for commodities and financial assets in real time. These prices are the building blocks for determining how other derivatives will be priced, and the price discovery process can be either centralized, as with an exchange, or decentralized, as with an OTC market.

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Risk Statement: Trading Foreign Exchange on margin carries a high level of risk and may not be suitable for all investors. The possibility exists that you could lose more than your initial deposit. The high degree of leverage can work against you as well as for you.