Transaction costs set the economic boundary between a profitable trade and a loss. Ronald Coase University of Chicago demonstrated that transaction costs determine whether and how markets organize activity, and that insight applies directly to short-term currency arbitrage: only price discrepancies that exceed cumulative trading costs — explicit fees plus implicit frictions — are exploitable. When the sum of bid–ask spreads, brokerage fees, market-impact costs, funding and credit charges, and latency exceeds the apparent mispricing, arbitrage disappears.
Market microstructure and execution frictions
Research in exchange-rate microstructure by Richard Lyons University of California, Berkeley shows that order flow, dealer inventory management, and information asymmetries create persistent microprice differences across venues and time. These frictions translate into execution uncertainty: an expected profit can evaporate between signal and fill. John Hasbrouck New York University has documented how market impact and depth affect realized costs, so short-lived arbitrage windows often require either superior speed or lower marginal cost to capture value. The Bank for International Settlements reports that turnover, liquidity, and spreads vary widely across currency pairs and trading hours Bank for International Settlements, which shapes where and when arbitrage is feasible.
Causes and territorial nuances
Several structural causes amplify transaction costs. Fragmented trading venues and differing settlement systems across jurisdictions force cross-border arbitrageurs to manage counterparty and settlement risk, raising funding and regulatory compliance costs. Capital controls, local market conventions, and varying levels of market transparency introduce cultural and territorial constraints that can sustain pricing gaps that appear arbitrageable but are economically inaccessible to outsiders. In emerging-market FX, for example, higher spreads and lower depth documented by the Bank for International Settlements make rapid arbitrage more costly and riskier.
Consequences extend beyond lost profits. Higher transaction costs reduce the frequency of corrective trades, allowing mispricings to persist longer and increasing the informational role of liquidity providers. They concentrate short-term arbitrage activity among well-capitalized, technologically advanced firms willing to pay for colocation and dedicated connectivity, with nuanced social and environmental implications such as concentrated employment in financial hubs and increased energy use for ultra-low-latency infrastructure.
Policymakers and market operators can influence arbitrage economics by addressing settlement inefficiencies, promoting transparency, and standardizing rules — interventions that, as Coase’s framework suggests, change the very structure of profitable market activity. Understanding transaction costs therefore explains not just whether arbitrage exists, but who can exploit it and what broader market and territorial patterns emerge.