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Microstructure Theory and the Foreign Exchange Market

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Microstructure Theory and the Foreign Exchange Market 52 Mark D. Flood Mark D. Flood is an economist at the Federal Reserve Bank of St. Louis. David H. Kelly provided research assistance. Microstructure Theory and the Foreign Exchange Market GROWING BODY OF theoretical literature, exchange market is also of special interest to known as the study of securities market micro- students of microstructure, because it combines structure, deals with the behavior of participants two very different arrangements for matching in securities markets and with the effects of in- buyers and sellers — bank dealers trade with formation and institutional rules on the economic one another both directly and through foreign performance of those markets. These institu- exchange brokers.1 tional factors may arise from technology, tradi- Standard models of exchange-rate determina- tion or regulation. Microstructure and its impact tion concentrate on relatively long-run aspects, are important, because of the vast amounts of such as purchasing power parity. While micro- wealth which pass through securities markets — structure theory cannot address these issues including the foreign exchange market — directly, it can illuminate a more narrowly fo- every day. cused array of institutional concerns, such as Microstructure is of interest to students of the price information, the matching of buyers and foreign exchange market: microstructural analy- sellers, and optimal dealer pricing policies. De- ses of other markets have yielded insight into spite the substantial literature on microstructure, traders’ behavior and the effect of various insti- little attention has been paid to the particular tutional arrangements. Conversely, the foreign microstructure of the foreign exchange market.2 ‘Similar arrangements exist for other securities—for exam- Cohen, Maier, Schwartz and Whitcomb (1979, 1986) and ple, the federal funds market and the secondary market Stoll (1985) have surveyed the microstructure literature. for Treasury securities—but these too have been relatively In addition to the early note by Allen (1977), very recently neglected in the literature. 2 there have appeared some microstructural studies of the The shaded insert on the opposite page provides a context foreign exchange market: Bossaerts and Hillion (1991), in which the microstructural approach can be compared Lyons (1991), Rai (1991) and Flood (1991). There is also with more traditional approaches to market efficiency. an empirical literature measuring the determinants of the Following some early articles by Demsetz (1968), Tinic bid-ask spread in the foreign exchange market. See Black (1972) and Tinic and West (1972), Garman (1976) per- (1989), Wei (1991) and Glassman (1987) as well as the formed the crucial task of defining market microstructure references therein. Because the focus of this article is on as an independent area of the literature, thus focusing the microstructure theory, such empirical studies receive little debate. Since then, market microstructure has burgeoned, attention here. led by Cohen, Maier, Schwartz and Whitcomb (1978a, Finally, although a consideration of the results of laborato- 1978b, 1981, 1983), Amihud and Mendelson (1980, 1986, ry experiments would expand the scope of this paper to 1988), Stoll (1978, 1985, 1989) and Ho and Stoll (1980, unwieldy dimensions, their role in establishing the sensitiv- 1981). See also Beja and Hakansson (1977), Cohen, ity of market behavior to institutional factors must at least Hawawini, Maier, Schwartz and Whitcomb (1980), Cohen, be acknowledged; see Plott (1982, 1991) for an in- Maier, Ness, Okuda, Schwartz and Whitcomb (1977), Ami- troduction. hud, Ho, and Schwartz (1985), Schreiber and Schwartz (1986), Schwartz (1988) and Cohen and Schwartz (1989). FEDERAL RESERVE BANK OF St LOUIS I 53 NS ~ .— —\ / ~c ~., ~‘Ti~_ ~. ~ ~4 C,’ ~‘ ~/< /\ ~ /~ ~~ S ~/C~/~~t ~ ~ .~ ~ ~~ <‘/‘~Cfr~/’ ~?~ çY~, ~ ~ // ~ 4 ~ S ~~ <~ , ~~. ; ..\ , ~~/ ~/~~~7/ ~ ~ “Ye ~~ /~“ I ~ H~~ C ~:i~, : ci:: ~1c~’:1/ // , .~ < ~/\~ ~ ~ /~\,~ /~/~ y ~ ~~. ~ c ~‘ I ~ ::~“ ~‘ I ~ ~ ~.,t. .~ 4~~// ~ / ~ ~ / “ ~. : ~~ I ~~ ~ ~~ ~ ~ ~[T~:< .c\~~ ~ ‘ ~. ~ ~ ~ ~ </ ~~1 ~~,\ ~ I ~ ‘ ~ ‘ ~ ~ ,~&~ ~ ‘“< ~‘ ~ ~4’w\ ~ ,\ ~ ,,~ .~ ~ / ~~ ,~ ~~ ~ ,...~., ~../.4\.:~t~r ~ ~ ~ .( 1iz:,~ ~‘ ~ < ~~‘1 ~ ‘~ \~ ~<..~ ‘ a ~ ~ p / ~ < /~~ ~. \~v‘ ~ ~ :~ ~ ~ ‘ ~ \ a ~ /~ ~\ *c~ ~/~c~j ~*/ ~c~: .~ ~ ~~/,~ S ~ \~~// ~4( ~ ~ // ~~ f, ~ ~J:::~?:/\ ~ ~~C “~ /‘~A \~ , ‘/ ~ a , j. ~~~ ‘ ~i~~ ~ ~~ / .1 .~ ~~,~~~.4~/ , ~\ a ~ t~’ ~ ~4*t , ~ ~-< ~ ~ ~ ; a /~d ~bSJ.~ ‘~‘z~ ~ 4!øv ./ /~ ~ ~. S~ ~p~~~~~ S N N “* ~ ~*v ~ 11 N~ N ~ 1* ~N/~/: ~id ~~ S /~\~ ~~ ~~ /7\~ // / /~—/ ~, iS ~ N ~ ~ 4~. N ~N .~ ~ ~ N ~ h~t~~. ~ —~// ~ ‘:~ ~~ ~‘ ~:~~f // ~‘ : i1~t ‘~ ~~ ~/ , ~ t~!sI~* ~ N~ ~1/N~‘ ,~ ~ ~ N ~ r ~nnptneJ NN N I : 0 ~ /~/~ ‘~/~ ~ ~ ~\N~/~\\ N~ ~ / ~ *&#c+ ‘ ~ ~ /;4 I 0 , ‘ t,~ ~~/\\ ~\\ I N tiasi ~ // \<\ ~ /. ,. SaSw~oSL1ktrstus~. I N ~ ~t*~iS aø~ ‘~ ~ / \/ / ~ ,, ~ ~ N ~~tj4boDX~ t,,~ 4~Ø4fJØfl N a \~Nt\Sc :: ~ ~ tp*s’ ~ ‘ ~ ‘, ~: , N 4~~ ‘ \/ \ /~ ~ I N \/ N N V~ sastt/ / NA V 4I~ts*twb~,.N,,,,, / N ,~ ,,VN/N ~ N a~NN )~ostra~flN N \N NN / t/N~ ‘~ ~~/C/ ‘~/“/\./.‘ N S~PäS4I ‘~tM%SS bt Ike N / a~aismetantsewa~198~~ NN 1 ~ N N NN N N .1’ / ~. / N I SS stWaat t%Sflot S NN N N / IN NNN N NNN NNN “N N NN N/\~~ N’~N’N ‘~\~\~/ ,NNNN\\ ,NIN S ~ N N, N N’ ~ N N~, N’ N N N NN NNIN/\NN..\ ‘‘N/¼’N~N/.\ N N N NNN N “N N NN NNN N’ ‘N N ~, N,\N\N/’ ~N N ‘NN N I ~NN NN N,NN~~NN\\ININN,\~ NOVEMBER/DECEMBER 1991 54 This paper examines the extant literature on market microstructure to determine how it might be applied to the foreign exchange Figure 1 market. Spot Market Volume by The paper begins with a brief description of Transactor (4/89) the foreign exchange market. Aspects of the customer literature concerned with institutional details (5.1%) are addressed second, noting how such details can affect the performance of the market. Next, the literature dealing with behavioral details, es- pecially the communication and interpretation of price information, is considered. Finally, the interaction of institutional and behavioral fac- tors, notably the bid-ask spread, is discussed. INSTITUTIONAL BASICS OF THE FOREIGN EXCHANGE MARKET The foreign exchange market is the interna- tional market in which buyers and sellers of currencies “meet.”3 It is largely decentralized: the participants (classified as market-makers, (55.0%) brokers and customers) are physically separated ‘Interbank Brokered from one another; they communicate via tele- (39.9%) phone, telex and computer network. Trading volume is large, estimated at $128.9 billion for the U.S. market in April 1989. Most of this trad- change rates or simply to complete their own ing was between bank market-makers.~ international transactions. Market-makers may trade for their own account — that is, they may The market is dominated by the market-makers maintain a long or short position in a foreign at commercial and investment banks, who trade currency — and require significant capitalization currencies with each other both directly and for that purpose. Brokers do not contact cus- through foreign exchange brokers (see figure IL” tomers and do not deal on their own account; Market-makers, as the name suggests, “make a instead, they profit by charging a fee for the market” in one or more currencies by providing service of bringing market-makers together. bid and ask prices upon demand. A broker ar- ranges trades by keeping a “book” of market- The mechanics of trading differ substantially between brokered transactions and direct deals. maker’s limit orders — that is, orders to buy (al- In the direct market, banks contact each other. ternatively, to sell) a specified quantity of for- The bank receiving a call acts as a market-maker eign currency at a specified price — from which he quotes the best bid and ask orders upon re- for the currency in question, providing a two- quest. The best bid and ask quotes on a broker’s way quote (bid and ask) for the bank placing book are together called the broker’s “inside the call. A direct deal might go as follows: spread.” The other participants in the market Mongobank: “Mongobank with a dollar-mark are the customers of the market-making banks, please?” who generally use the market to complete (Mongobank requests a spot market quote transactions in international trade, and central for U.S. dollars (USD) against German marks banks, who may enter the market to move ex- (DEM).) 3 For more thorough descriptions of the workings of the for- has roughly doubled every three years for the past eign exchange market, see Burnham (1991), Chrystal decade. 5 (1984), Kubarych (1983) and Riehl and Rodriguez (1983). Federal Reserve Bank of New York (l989a) lists 162 4 See Federal Reserve Bank of New York (1989a) and Bank market-making institutions (148 are commercial banks) and for International Settlements (815) (1990). Extending this 14 brokers; an earlier study, Federal Reserve Bank of New figure over 251 trading days per year, this implies a trad- York (1980), lists 90 market-making banks and 11 brokers. ing volume of roughly $32 trillion for all of 1989. Volume FEDERAL RESERVE BANK OF St LOUIS 1 55 Loans ‘n Things: “20-30” orders are also provided in part as a courtesy I (Loans n’ Things will buy dollars at 2.1020 to the brokers as part of an ongoing business DEM/USD and sell dollars at 2.1030 DEM/USD relationship that makes the market more liquid. —the 2.10 part of the quote is understood.) Because his limit order is often a market-maker’s first indication of general price shift, Brooks Mongohank: “Two mine.” likens the posting of an order with a broker “to I (Mongobank buys $2,000,000 for DEM sticking out the chin so as to be acquainted 4,206,000 at 2.1030 DEMIUSD, for payment with the moment that the fight starts.”8 Schwartz two business days later. The quantity traded points out that posting a limit order extends a I is usually one of a handful of “customary free option to other traders.~ amounts.”) Loans ‘n Things: “My marks to Loans ‘n A market-maker who calls a broker for a quote I Things Frankfurt.” gets the broker’s inside spread, along with the (Loans n’ Things requests that payment of quantities of the limit orders.
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