When the Spread Stops Pricing Risk
- Finance
ThePostMaster- 0
- 34 minutes read
Across financial markets, the bid-offer spread has always served a fundamental purpose. Whether prices are formed through dealer negotiation, brokered interaction, or electronic matching, the spread was the price of risk. It compensated a liquidity provider for holding inventory, absorbing uncertainty, and managing the time, capital, and information asymmetry involved in finding the other side of a trade.
The mechanics differed by market, but the principle was consistent. When risk increased, spreads widened. When liquidity deteriorated, prices adjusted. The spread acted as a shock absorber, translating market stress into visible cost.
That relationship has weakened. Not just in electronic markets, but across asset classes and execution styles.
Over time, competitive pressure has compressed spreads to levels increasingly disconnected from underlying risk. What began as efficiency has, in many cases, become distortion. The spread still exists, but it no longer consistently performs the function it was designed for.
From Risk Price to Competitive Signal
Historically, spreads were set with reference to absolute risk. Dealers widened prices when available liquidity thinned, hedging depth deteriorated, volatility increased, or balance sheet costs rose. The spread adjusted to reflect the cost of carrying exposure through uncertainty.
In many modern market environments, that logic has shifted.
Where pricing is continuously visible, easily comparable, and frequently used as a point of differentiation, the spread increasingly functions as a competitive signal rather than a risk premium. The dominant question is no longer what this risk costs to hold, but how this price looks relative to others offering the same product.
As long as pricing remains broadly in line with the surrounding market, it is considered acceptable. The spread becomes something to be defended, not something to be discovered.
This distinction matters because relative pricing behaves very differently under stress. When spreads are anchored to peer comparison rather than underlying conditions, they lose their ability to expand naturally as volatility rises. The market still experiences the same risk, but that risk is prevented from expressing itself through price.
Instead of being absorbed by the spread, it is carried elsewhere in the system.
In recent work analysing pricing behaviour across different market environments, and in discussions I have had with multiple firms, a recurring theme has emerged. Pricing decisions are often optimised around relative positioning, while the underlying mechanics of liquidity availability, inventory accumulation, hedging reliability, and balance sheet exposure are treated as secondary considerations. The result is pricing that appears competitive in isolation but becomes brittle when conditions change.
Market Structure Does Not Change the Outcome
It is tempting to frame this dynamic as a by-product of electronic trading, but that misses the point. I have seen the same pattern emerge wherever markets are highly competitive and pricing is easy to compare.
As information asymmetry declines and execution becomes more standardised, spreads converge on the tightest level that avoids immediate arbitrage. Over time, that level drifts away from the true cost of holding risk.
The execution method changes. The incentive structure does not.
When competition is centred on headline pricing rather than risk absorption, the spread stops acting as a stabilising mechanism and starts acting as a constraint.
Recent Volatility Has Made the Issue Harder to Ignore
The increased volatility seen in precious metals over recent weeks has brought this issue back into focus. In multiple recent discussions I have had with market participants, the same questions have surfaced repeatedly. Why did pricing feel stable until it suddenly was not? Why did relatively small moves produce outsized inventory swings? And why did risk controls engage faster than expected?
Gold and silver have experienced sharp intraday moves, sudden repricing, and rapid changes in liquidity conditions. Volatility regimes have shifted quickly, often faster than pricing frameworks have adjusted. In several sessions, price action has looked more like stress behaviour than routine market fluctuation.
The movement of Gold price over the last 1 month
In calmer periods, compressed spreads in metals appear benign. Execution looks efficient. Costs look low. But during recent volatile sessions, the mismatch between price and risk has been harder to overlook.
Spreads that remain structurally tight during fast markets do not dampen volatility. They amplify its impact on liquidity providers. Inventory accumulates more quickly. Hedging costs rise abruptly. Small misalignments translate into disproportionately large P&L swings.
In environments where pricing is slow to adjust, volatility is not absorbed by the spread. It is absorbed by the balance sheet.
The movement of Silver price over the last 1 month
Some Clients Really Do Trade the Spread
It is also true that some clients do not treat spreads as a marketing metric. They trade them.
There is a cohort running scalping and price-dislocation strategies, seeking to extract small, repeatable price increments or exploit brief mid-price misalignments. In effect, they are monetising micro-dislocations, latency, and stale quoting. That behaviour is part of what keeps competitive pressure on displayed pricing even when underlying conditions would justify wider markets.
The irony is that this does not make tight spreads more client-friendly. It makes them more structurally important to defend. If the market is forced to hold tight pricing while liquidity thins and hedging depth deteriorates, risk does not vanish. It migrates into inventory swings, slippage, asymmetric execution, and abrupt changes in trading conditions.
The clients who rely on micro-edges will continue to push for the thinnest possible buffer. The long-run outcome is often a less stable trading environment for everyone else.
Where the Risk Actually Goes
When spreads no longer price risk, that risk is not eliminated. It is displaced.
It moves into internal buffers, inventory limits, execution controls, and operational responses that are far less visible to end users. This can surface as increased slippage, reduced liquidity availability during fast markets, delayed execution, or sudden changes to trading conditions.
When reviewing these episodes across different firms and market conditions over time, what has struck me most is how consistent the pattern is. The firms that experience the most strain are rarely those with the widest spreads in calm markets. They are more often those where pricing models have evolved incrementally without being retested against how liquidity, volatility, and hedging interact under stress.
From the outside, this distinction is rarely obvious until something breaks, and by that point the root cause is often obscured by the symptoms.
The Recurring Appeal of Discipline, and Why It Fails
Periods of stress tend to trigger the same conclusion: spreads that remain structurally tight during volatile conditions do not create better outcomes; they relocate risk into less visible parts of the system. A more volatility-aware approach to pricing would, in principle, benefit everyone over the long run. It reduces the frequency of destabilising inventory swings, supports more consistent execution, and makes intermediaries more resilient when markets gap and reprice.
In off-record conversations over recent weeks, I have heard variants of the same idea raised more than once. If everyone widened to a sensible baseline during stressed conditions, the market would likely be more stable, execution would be more consistent, and intermediaries would be less prone to sudden defensive measures. The problem is not the intuition; it is the structure.
The market cannot rely on collective discipline to achieve this. Pricing is a competitive signal, and competitive signals get undercut. Even if many participants privately recognise that risk is being underpriced in stressed markets, the incentive to be the tightest quote for acquisition is persistent. It only takes one participant to reset expectations for everyone else.
This is not a coordination problem. It is a structural incentive problem.
What Clients Actually Care About
Many end users are obsessed with the spread. It is one of the first numbers they look at and one of the easiest to compare. In practice, it is largely irrelevant to the outcome they actually experience.
What matters is the price they execute at on entry and the price they execute at on exit.
At the moment of a trade, a seller only interacts with the bid. A buyer only interacts with the offer. The spread is simply the distance between two displayed numbers, but the trader never transacts at the mid and never transacts at the spread. They transact at a single executable price.
This is why headline spreads can be such a distraction. They are easy to market and easy to compare, but they tell you very little about realised cost. Realised cost is shaped by slippage, rejects, latency, and how pricing behaves when markets move quickly. A narrow spread that collapses under stress is not a lower-cost environment. It is simply a different way of charging for risk, one that appears through execution quality rather than through a visibly wider quote.
Once you view the problem through executable prices and realised outcomes, the next step becomes clear. You measure what traders actually experience on entry and exit, identify where behaviour breaks under stress, and govern pricing to behave consistently across regimes.
The Action That Needs Fixing
The fix is not a slogan about wider spreads, and it is not a race to the tightest quote. The action is to reconnect pricing to the risk it is meant to absorb, using measurable, testable controls.
That means separating the marketing view of price from the execution and risk reality of price. It means measuring realised trading outcomes by regime, not just displayed spreads in calm conditions.
Firms that handle volatility best tend to do a few things consistently:
● They monitor realised execution outcomes by instrument and regime, including slippage distribution, reject rates, and behaviour during fast markets.
● They treat spread behaviour as a governed policy, with explicit triggers tied to liquidity conditions and hedging depth, not just headline volatility.
● They stress-test pricing rules against recent stress sessions, particularly in products like gold and silver, where conditions can reprice rapidly.
● They analyse the interaction between flow composition, quote stability, and hedging performance instead of looking at each in isolation.
None of this requires a reinvention of market making. It requires a structured diagnostic, cross-functional alignment, and the discipline to define explicitly how pricing should behave when markets move.
I have seen firms materially improve resilience by doing this work properly, because it turns a debate about spreads into a concrete engineering and governance problem with observable outputs.
What Volatility Is Telling Us
Volatility does not create these problems. It reveals them.
Recent moves in gold and silver have acted as a reminder that pricing is not just a competitive tool. It is a risk management mechanism. When that mechanism stops functioning properly, stress shows up elsewhere.
The real challenge is not whether spreads should be wide or tight, but whether they remain connected to the risks they are meant to represent.
In the end, the spread is not just a number. It is a mechanism. When it stops doing its job, volatility eventually reminds everyone why it existed in the first place.
Across financial markets, the bid-offer spread has always served a fundamental purpose. Whether prices are formed through dealer negotiation, brokered interaction, or electronic matching, the spread was the price of risk. It compensated a liquidity provider for holding inventory, absorbing uncertainty, and managing the time, capital, and information asymmetry involved in finding the other side of a trade.
The mechanics differed by market, but the principle was consistent. When risk increased, spreads widened. When liquidity deteriorated, prices adjusted. The spread acted as a shock absorber, translating market stress into visible cost.
That relationship has weakened. Not just in electronic markets, but across asset classes and execution styles.
Over time, competitive pressure has compressed spreads to levels increasingly disconnected from underlying risk. What began as efficiency has, in many cases, become distortion. The spread still exists, but it no longer consistently performs the function it was designed for.
From Risk Price to Competitive Signal
Historically, spreads were set with reference to absolute risk. Dealers widened prices when available liquidity thinned, hedging depth deteriorated, volatility increased, or balance sheet costs rose. The spread adjusted to reflect the cost of carrying exposure through uncertainty.
In many modern market environments, that logic has shifted.
Where pricing is continuously visible, easily comparable, and frequently used as a point of differentiation, the spread increasingly functions as a competitive signal rather than a risk premium. The dominant question is no longer what this risk costs to hold, but how this price looks relative to others offering the same product.
As long as pricing remains broadly in line with the surrounding market, it is considered acceptable. The spread becomes something to be defended, not something to be discovered.
This distinction matters because relative pricing behaves very differently under stress. When spreads are anchored to peer comparison rather than underlying conditions, they lose their ability to expand naturally as volatility rises. The market still experiences the same risk, but that risk is prevented from expressing itself through price.
Instead of being absorbed by the spread, it is carried elsewhere in the system.
In recent work analysing pricing behaviour across different market environments, and in discussions I have had with multiple firms, a recurring theme has emerged. Pricing decisions are often optimised around relative positioning, while the underlying mechanics of liquidity availability, inventory accumulation, hedging reliability, and balance sheet exposure are treated as secondary considerations. The result is pricing that appears competitive in isolation but becomes brittle when conditions change.
Market Structure Does Not Change the Outcome
It is tempting to frame this dynamic as a by-product of electronic trading, but that misses the point. I have seen the same pattern emerge wherever markets are highly competitive and pricing is easy to compare.
As information asymmetry declines and execution becomes more standardised, spreads converge on the tightest level that avoids immediate arbitrage. Over time, that level drifts away from the true cost of holding risk.
The execution method changes. The incentive structure does not.
When competition is centred on headline pricing rather than risk absorption, the spread stops acting as a stabilising mechanism and starts acting as a constraint.
Recent Volatility Has Made the Issue Harder to Ignore
The increased volatility seen in precious metals over recent weeks has brought this issue back into focus. In multiple recent discussions I have had with market participants, the same questions have surfaced repeatedly. Why did pricing feel stable until it suddenly was not? Why did relatively small moves produce outsized inventory swings? And why did risk controls engage faster than expected?
Gold and silver have experienced sharp intraday moves, sudden repricing, and rapid changes in liquidity conditions. Volatility regimes have shifted quickly, often faster than pricing frameworks have adjusted. In several sessions, price action has looked more like stress behaviour than routine market fluctuation.
The movement of Gold price over the last 1 month
In calmer periods, compressed spreads in metals appear benign. Execution looks efficient. Costs look low. But during recent volatile sessions, the mismatch between price and risk has been harder to overlook.
Spreads that remain structurally tight during fast markets do not dampen volatility. They amplify its impact on liquidity providers. Inventory accumulates more quickly. Hedging costs rise abruptly. Small misalignments translate into disproportionately large P&L swings.
In environments where pricing is slow to adjust, volatility is not absorbed by the spread. It is absorbed by the balance sheet.
The movement of Silver price over the last 1 month
Some Clients Really Do Trade the Spread
It is also true that some clients do not treat spreads as a marketing metric. They trade them.
There is a cohort running scalping and price-dislocation strategies, seeking to extract small, repeatable price increments or exploit brief mid-price misalignments. In effect, they are monetising micro-dislocations, latency, and stale quoting. That behaviour is part of what keeps competitive pressure on displayed pricing even when underlying conditions would justify wider markets.
The irony is that this does not make tight spreads more client-friendly. It makes them more structurally important to defend. If the market is forced to hold tight pricing while liquidity thins and hedging depth deteriorates, risk does not vanish. It migrates into inventory swings, slippage, asymmetric execution, and abrupt changes in trading conditions.
The clients who rely on micro-edges will continue to push for the thinnest possible buffer. The long-run outcome is often a less stable trading environment for everyone else.
Where the Risk Actually Goes
When spreads no longer price risk, that risk is not eliminated. It is displaced.
It moves into internal buffers, inventory limits, execution controls, and operational responses that are far less visible to end users. This can surface as increased slippage, reduced liquidity availability during fast markets, delayed execution, or sudden changes to trading conditions.
When reviewing these episodes across different firms and market conditions over time, what has struck me most is how consistent the pattern is. The firms that experience the most strain are rarely those with the widest spreads in calm markets. They are more often those where pricing models have evolved incrementally without being retested against how liquidity, volatility, and hedging interact under stress.
From the outside, this distinction is rarely obvious until something breaks, and by that point the root cause is often obscured by the symptoms.
The Recurring Appeal of Discipline, and Why It Fails
Periods of stress tend to trigger the same conclusion: spreads that remain structurally tight during volatile conditions do not create better outcomes; they relocate risk into less visible parts of the system. A more volatility-aware approach to pricing would, in principle, benefit everyone over the long run. It reduces the frequency of destabilising inventory swings, supports more consistent execution, and makes intermediaries more resilient when markets gap and reprice.
In off-record conversations over recent weeks, I have heard variants of the same idea raised more than once. If everyone widened to a sensible baseline during stressed conditions, the market would likely be more stable, execution would be more consistent, and intermediaries would be less prone to sudden defensive measures. The problem is not the intuition; it is the structure.
The market cannot rely on collective discipline to achieve this. Pricing is a competitive signal, and competitive signals get undercut. Even if many participants privately recognise that risk is being underpriced in stressed markets, the incentive to be the tightest quote for acquisition is persistent. It only takes one participant to reset expectations for everyone else.
This is not a coordination problem. It is a structural incentive problem.
What Clients Actually Care About
Many end users are obsessed with the spread. It is one of the first numbers they look at and one of the easiest to compare. In practice, it is largely irrelevant to the outcome they actually experience.
What matters is the price they execute at on entry and the price they execute at on exit.
At the moment of a trade, a seller only interacts with the bid. A buyer only interacts with the offer. The spread is simply the distance between two displayed numbers, but the trader never transacts at the mid and never transacts at the spread. They transact at a single executable price.
This is why headline spreads can be such a distraction. They are easy to market and easy to compare, but they tell you very little about realised cost. Realised cost is shaped by slippage, rejects, latency, and how pricing behaves when markets move quickly. A narrow spread that collapses under stress is not a lower-cost environment. It is simply a different way of charging for risk, one that appears through execution quality rather than through a visibly wider quote.
Once you view the problem through executable prices and realised outcomes, the next step becomes clear. You measure what traders actually experience on entry and exit, identify where behaviour breaks under stress, and govern pricing to behave consistently across regimes.
The Action That Needs Fixing
The fix is not a slogan about wider spreads, and it is not a race to the tightest quote. The action is to reconnect pricing to the risk it is meant to absorb, using measurable, testable controls.
That means separating the marketing view of price from the execution and risk reality of price. It means measuring realised trading outcomes by regime, not just displayed spreads in calm conditions.
Firms that handle volatility best tend to do a few things consistently:
● They monitor realised execution outcomes by instrument and regime, including slippage distribution, reject rates, and behaviour during fast markets.
● They treat spread behaviour as a governed policy, with explicit triggers tied to liquidity conditions and hedging depth, not just headline volatility.
● They stress-test pricing rules against recent stress sessions, particularly in products like gold and silver, where conditions can reprice rapidly.
● They analyse the interaction between flow composition, quote stability, and hedging performance instead of looking at each in isolation.
None of this requires a reinvention of market making. It requires a structured diagnostic, cross-functional alignment, and the discipline to define explicitly how pricing should behave when markets move.
I have seen firms materially improve resilience by doing this work properly, because it turns a debate about spreads into a concrete engineering and governance problem with observable outputs.
What Volatility Is Telling Us
Volatility does not create these problems. It reveals them.
Recent moves in gold and silver have acted as a reminder that pricing is not just a competitive tool. It is a risk management mechanism. When that mechanism stops functioning properly, stress shows up elsewhere.
The real challenge is not whether spreads should be wide or tight, but whether they remain connected to the risks they are meant to represent.
In the end, the spread is not just a number. It is a mechanism. When it stops doing its job, volatility eventually reminds everyone why it existed in the first place.
