Asymmetric Information and the Foreign-Exchange Trades of Global Custody Banks
40 Pages Posted: 22 Mar 2011 Last revised: 15 Sep 2015
Date Written: February 15, 2011
This paper examines how asymmetric information influences foreign-exchange trading between global custody banks and their client funds. The clients can negotiate prices with the custody bank dealers or simply instruct their representative at the custodian to carry out the trade. With non-negotiated trades, the custodian unilaterally sets the price and the client learns that price after a delay measured in days or weeks. We hypothesize that bid-ask spreads are higher on non-negotiated trades because the clients face relatively steep obstacles to monitoring trading costs and because the clients find such trades less administratively costly to themselves. We also suggest that custody banks are motivated to preserve any ambiguity surrounding trading costs. Since wider bid-ask spreads reduce the returns to the client’s ultimate investors, we also hypothesize that clients are more likely to negotiate prices for larger trades. Our data comprise the complete foreign exchange trading record of a mid-sized custody bank during calendar year 2006. Regression analysis provides support for all three hypotheses.
Keywords: Exchange rates, Microstructure, Asymmetric Information, Custody Banks
JEL Classification: G1, F3
Suggested Citation: Suggested Citation