FX Market Liquidity, Funding Constraints and Capital Flows

46 Pages Posted: 11 Jun 2012 Last revised: 17 Oct 2014

See all articles by Chiara Banti

Chiara Banti

University of Essex

Kate Phylaktis

City University London - Sir John Cass Business School

Date Written: October 16, 2014


We investigate the determinants of the time variation of the common component of FX market liquidity across developed and emerging market currencies. We study the impact of funding liquidity constraints, which proxy for supply considerations, and capital flows, which proxy for demand considerations of liquidity on transaction costs. Our results show that (i) funding liquidity constraints measured by the availability of outstanding repos reduce FX market liquidity, and their impact is stronger when they are associated with an increase in the costs of funding and a shortening of their maturity; (ii) increasing capital flows at the global level increase liquidity; (iii) both of these effects were stronger during the recent financial crisis, when liquidity dry-ups were severe; and (iv) the analysis of individual currencies with diverse riskiness confirms that a shock to speculator capital would lead to a reduction in market liquidity through a spiral effect that is stronger for more volatile currencies. Furthermore, we find a similar effect related to capital flows.

Keywords: foreign exchange, liquidity, funding liquidity constraints, capital flows, microstructure

JEL Classification: F31; G15

Suggested Citation

Banti, Chiara and Phylaktis, Kate, FX Market Liquidity, Funding Constraints and Capital Flows (October 16, 2014). Available at SSRN: https://ssrn.com/abstract=2081602 or http://dx.doi.org/10.2139/ssrn.2081602

Chiara Banti

University of Essex ( email )

Wivenhoe Park
Colchester, CO4 3SQ
United Kingdom

Kate Phylaktis (Contact Author)

City University London - Sir John Cass Business School ( email )

106 Bunhill Row
London, EC1Y 8TZ
United Kingdom
+44 20 70408735 (Phone)
+44 20 70408881 (Fax)

HOME PAGE: http://www.cass.city.ac.uk/faculty/k.phylaktis/

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