What is the order processing cost component of the spread?

Question

AcadiFi · Accepted Answer

Order processing cost is the compensation market-makers need to cover the fixed and operational costs of maintaining a market: exchange fees, clearing/settlement fees, technology infrastructure, regulatory capital requirements, personnel, and a normal profit margin. It's largely invariant to informational environment or inventory state — it's just the 'cost of doing business'.

Drivers:
1. Fixed exchange and regulatory fees per trade
2. Technology costs (co-location, market data feeds, algorithms)
3. Capital requirements (higher for riskier products)
4. Competition — more MMs compete the processing margin down
5. Tick size — larger ticks often allow for bigger processing margin

Example: Evermore Exchange Services maintains quotes in 300 equities. Estimated monthly costs: $450,000 technology, $180,000 personnel, $120,000 exchange/clearing, $90,000 capital charge = $840,000. If they execute 25 million shares/month, average processing cost = $0.0336/share ~= 3.4 cents, representing a meaningful portion of small-tick spreads.

Variation across markets: (a) large-cap equity has very low processing cost (cents per share on high volume), (b) small-cap equity has higher per-share (lower volume to amortize fixed costs), (c) corporate bonds and OTC derivatives have much higher processing costs due to voice/RFQ trading, lower automation, and wider regulatory capital requirements.

For FRM: processing cost is the 'floor' component — even in perfectly informed-free, inventory-neutral markets, spreads can't compress below this level. When evaluating liquidity stress, processing costs are sticky while adverse-selection and inventory components spike.

What is the order processing cost component of the spread?

Master Part II with our FRM Course

Related Questions

Practice Questions