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How Do Zero Commissions Currency Exchanges Work?

The P2P financial markets are yet to converge. In Latin America, there are a lot of actors in the market offering excellent financial services, from money transfers to banking, retail trading, insurance, and so on and so forth.

Today's post will focus on P2P currency exchanges, unlicensed international money transfer services, and unlicensed retail currency exchanges, which often comprise individuals executing transactions manually with their personal bank accounts. These unlicensed currency exchanges are more common than you think in Latin America.

Currency exchanges need to make money. Otherwise, they would not exist. The leading questions immediately pop into my mind are: Why would they offer such a service for free? How do they make money?

In Latin America, countries with troubled economies such as Venezuela and Argentina have dominant parallel markets. They actually mean unlicensed over-the-counter currency exchanges that execute transactions adhering to public indicators from social media and websites out of the regulated financial system for a less opaque definition. It's far riskier, but it's what works for the ordinary citizen in the region to remain financially competitive. Of course, P2P currency exchanges and unlicensed retail currency exchangers leverage this market opaqueness to maximize profits.

The risks associated with unlicensed currency exchanges are not insured for capital losses. If they incur fraud and you lose money, there's no one you can turn your head to. What you were doing by using these exchanges can be alleged to be money laundering, tax evasion, or worse. They rely only on the reputation of who recommends it to you, and since "past performance isn't indicative of future results," they can become fraudulent at any point in the future. There are no guarantees about the business's permanence other than doing business with them today or tomorrow.

These parallel markets, the smaller they are, the easier they are to manipulate with. Any relatively large movement towards the market will shake liquidity partners and considerably increase or decrease currency rates.

The massive fragmentation of the parallel market creates an excellent opportunity for trading slippage to occur. Many small sellers with many small buyers, cause that sellers may have to sell to several buyers fragments of the same capital, at many different prices.

So, How Do These Unlicensed Currency Exchanges Make Money?

The business of zero commissions unlicensed currency exchanges comprises two elements: maximization of the bid-ask spread and arbitrage. Purchasing a financial asset and then selling it is not without consideration of the "Where's this asset (USD, EUR, etc.) most valuable at?" question.

As an unlicensed currency exchange, it turns out there's a solid incentive to switch to the zero commissions model, in which variable bid-ask spreads can be squeezed out to maximize profits. Any profits an exchange can lose into this model can be earned back again x-fold in the future, and it irons out over time. One of the considerations of this structure is withdrawal fees between platforms (for arbitrage). Still, as long as the math checks out, profits can be created in a virtuous cycle.

The more significant the spread gap, the more profitable it is for the currency exchange. Of course, this makes customers go away, but when they are in dire need, there's no choice but to succumb to these disadvantageous currency rates. This happens especially on their payday.

Whether regulated or not, data is king in the world of exchanges. Actionable, relevant, timely data rules the world of the entire business operation. Flake on any of these characteristics, and the exchange will almost certainly lose money. What drives the advancement of the financial markets is the efficiency in which trades are executed, aside from solid demand and a covering offer to correspond. Currency exchanges that track market data, whether via a live feed or just by using spreadsheets software if the exchange is small enough, are lightyears ahead of those who don't.

For opaque parallel markets currency exchangers, it's contacts and networking. Who you know makes or breaks your unlicensed currency exchange business, mainly because it might not have enough liquidity to cover the existing demand or get in trouble (read as "fraud") faster than others. Individuals who engage in these transactions must be skilled at negotiating currency rates lest they lose money for any efficiency not exploited.

Any asset they buy looks for the lowest price and then withdraws to another platform where these can be sold at the highest price possible. For example:

  1. Jane Doe buys the USD digital balance from John Doe, using a popular payments platform for remote workers, paying him using local currency.
  2. Jane Doe withdraws this money to her bank account, knowing that bank dollars are more valuable than digital dollars of the said payment platform.
  3. Jane Doe then proceeds to sell these bank dollars to another individual. She receives more local currency than the amount she used to purchase the USD from Step 1.
  4. Jane Doe repeats the steps by finding a new seller, ever more exploiting any efficiencies she can out of this virtuous cycle.

Unlicensed international money transfer services have to rely on this kind of currency exchange to run their operation. It's convenient for them to also offer awful currency rates because the broader the spread gap, the better their profits.

The fragmentation of the parallel market may drive up prices of goods and services for the ordinary citizen. The market's opaqueness helps the efficiency not be appropriately exploited. The merchant may not use the same exchange as their customers, causing a gap where the goods and services become more expensive over time.

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