BIS Papers No 90 Foreign exchange liquidity in the Americas Report submitted by a study group established by the BIS CCA Consultative Group of Directors of Operations (CGDO) and chaired by Susan McLaughlin, Federal Reserve Bank of New York Monetary and Economic Department March 2017 JEL classification: F31, G15 The views expressed are those of the authors and not necessarily the views of the BIS. This publication is available on the BIS website (www.bis.org). © Bank for International Settlements 2017. All rights reserved. Brief excerpts may be reproduced or translated provided the source is stated. ISSN 1609-0381 (print) ISBN 978-92-9259-035-2 (print) ISSN 1682-7651 (online) ISBN 978-92-9259-034-5 (online) Contents Executive summary ................................................................................................................................ iii Liquidity metrics ............................................................................................................................. iii Liquidity conditions ...................................................................................................................... iii Factors influencing liquidity conditions ............................................................................... iii I. Introduction ...................................................................................................................................... 1 II. Liquidity metrics and trends ...................................................................................................... 1 A. Ways of measuring FX liquidity ....................................................................................... 1 1. FX market liquidity metrics ...................................................................................... 2 2. Use of FX liquidity metrics by central banks ..................................................... 5 B. Liquidity conditions .............................................................................................................. 7 1. Market turnover ............................................................................................................ 7 2. FX illiquidity metric (adjusted bid-ask spreads) ............................................. 10 3. Illiquidity during episodes of market stress and flash events .................. 11 III. Factors influencing liquidity conditions .............................................................................. 15 A. US dollar and Canadian dollar ....................................................................................... 16 1. Changing role of traditional liquidity providers ............................................ 16 2. Internalisation, concentration and FX liquidity .............................................. 18 3. Technology, FX market fragmentation and liquidity ................................... 19 Box 1: The impact of technological innovation on liquidity provision in fragmented FX markets .................................................................................................... 20 4. The role of regulation............................................................................................... 21 B. Latin American currencies ................................................................................................ 22 1. Reduced role of banks and foreign currency supply in Latin American FX markets .................................................................................................................... 22 2. Domestic suppliers of foreign currency ............................................................ 25 3. Onshore-offshore market integration ............................................................... 27 Conclusions .............................................................................................................................................. 29 Annex A. Research of participating central banks on FX market liquidity ...................... 31 Annex B. Role of central bank operations in the FX market ................................................. 32 Annex C. Central bank perspectives on drivers of FX liquidity ............................................ 35 Annex D. Glossary, ISO codes and acronyms ............................................................................. 37 Annex E. Graphs and tables ............................................................................................................... 41 References ................................................................................................................................................ 48 CCA/CGDO Study Group on FX Liquidity .................................................................................... 51 Acknowledgements .............................................................................................................................. 52 BIS Papers No 90 i Executive summary This report (i) lists and discusses the metrics currently used by CGDO member central banks and market participants to assess FX market liquidity; (ii) describes liquidity conditions and recent trends based on some of those metrics, as well as information provided by a diverse set of market participants; and (iii) discusses the factors that appear to be influencing liquidity conditions for USD cross rates, with a focus on the CAD and currencies in Latin America. Liquidity metrics Definitions of liquidity vary but, for the purposes of this report, an FX market is considered liquid if an investor wishing to execute a transaction of a desired size can do so at or near the prevailing market price, relatively quickly, and with no material price impact. The report discusses a number of liquidity metrics that are currently used by market participants and that capture one or more dimensions of this definition of liquidity. Some of these metrics may have become less useful because of structural changes in FX markets. Thus, instead of focusing on a particular metric, market participants generally look at several metrics together to get an overall picture of FX market liquidity conditions. The report also indicates which metrics CGDO member central banks monitor and in which FX markets. Liquidity conditions The report draws on the BIS Triennial Survey for market turnover data to assess broad trends in the region’s FX markets. Furthermore, a modified bid-ask spread metric of liquidity, together with market commentary, is used to analyse liquidity changes in Latin American FX markets, as well as those for major USD currency pairs since the mid-2000s, and annual liquidity developments since the so-called taper tantrum in 2013. The report also examines liquidity conditions during several recent episodes of market stress, highlighting the magnitude and duration of changes in liquidity following an event. From these metrics, there are some indications that global FX market liquidity may have declined in recent years. For example, market turnover for the USD and major Latin American currencies fell between 2013 and 2016, reversing an upward trend observed since 2001. Episodes in which liquidity indicators deteriorated for extended periods (higher modified bid-ask spreads and declines in market depth) in several advanced economy currencies were observed in the later part of 2014 and particularly after the CHF float of January 2015. In contrast, increases in the modified bid-ask spread during such episodes of market stress were generally smaller in Latin American currencies. Factors influencing liquidity conditions Global FX markets. Discussions with market participants suggest that a variety of factors have influenced the structure and liquidity of global FX markets in recent years, including changes in technology and post-crisis financial reforms. BIS Papers No 90 iii Technology has had a large impact on the structure of the FX market, but views differ on whether it has increased or reduced FX liquidity overall. On the one hand, technology has lowered the cost of transactions in the FX market. By enabling a wider use of algorithmic and high-frequency trading strategies, as well as improving connectivity, it has helped match a wider array of liquidity providers and liquidity seekers. It has also facilitated the search for liquidity or suitable counterparties and bridged multiple platforms more cheaply than in the past. This has enabled smaller banks and other financial institutions to participate more directly in FX markets. Technology has also lowered the costs of trading for large bank dealers in recent years. As a result, manual traders have been replaced by a much smaller number of technologists and quants using more advanced algorithmic trading tools. Technology may partly explain data indicating that liquidity is higher in the internal FX markets of large dealers (where they act as liquidity providers and use algorithms to search for liquidity for their clients) than in the FX market at large. Finally, technology has helped offset the costs of executing large trades by implementing a sequence of small transactions, although this may still imply greater market risks. On the other hand, technology has contributed to FX market fragmentation by facilitating the internalisation of client flows in large dealer banks and by giving rise to new FX trading venues that have emerged as alternatives to traditional multilateral electronic trading platforms. Market fragmentation has, according to some market participants, increased the