Trading Too Expensively in the FX Market?

Forthcoming in Quantitative Finance. Link to the published article: DOI: 10.1080/14697688.2019.1615633

Posted: 25 Jul 2018 Last revised: 10 May 2019

See all articles by Milla Siikanen

Milla Siikanen

Tampere University of Technology

Ulrich Nögel

big xyt AG

Juho Kanniainen

Tampere University

Date Written: January 1, 2019

Abstract

In foreign exchange (FX) trading, an aggregator is used to connect traders with liquidity providers (LPs). In an aggregator, a trader receives a continuous stream of bid and ask quotes from a predefined set of LPs, and the difference between the best bid and ask prices over a set of liquidity streams is called an inside spread. In this paper, we empirically study liquidity in an FX aggregator and show that, on average, traders obtain a relatively tight spread with four or five streams; the use of more streams yields a marginal benefit only. For given numbers of liquidity streams, we determine the optimal combinations of streams minimizing the spread. Our findings indicate that most of the traders could — at least in theory reduce the average spread by more than half with the optimal combination of streams, and a trader could save significantly, even up to 0.18 basis points in dollars per €1 traded. However, traders may not be able to fully exploit improvements in spreads because, in practice, the liquidity streams are set by LPs and not by the trader. In addition, we find that Oomen's [Quantitative Finance, 17, 3, (2017)] model for the liquidity dynamics and contract formation process in the aggregator, which can be used to characterize the observed inside spread, fits our empirical data accurately, even under simplistic assumptions.

Keywords: FX Market, Liquidity, Aggregation, Transaction Costs

JEL Classification: G15

Suggested Citation

Siikanen, Milla and Nögel, Ulrich and Kanniainen, Juho, Trading Too Expensively in the FX Market? (January 1, 2019). Forthcoming in Quantitative Finance. Link to the published article: DOI: 10.1080/14697688.2019.1615633, Available at SSRN: https://ssrn.com/abstract=3208229 or http://dx.doi.org/10.2139/ssrn.3208229

Milla Siikanen (Contact Author)

Tampere University of Technology ( email )

P.O. 541, Korkeakoulunkatu 8 (Festia building)
Tampere, FI-33101
Finland

Ulrich Nögel

big xyt AG ( email )

Kettenhofweg 55
Frankfurt am Main, 60325
Germany

Juho Kanniainen

Tampere University ( email )

P.O. 541, Korkeakoulunkatu 8 (Festia building)
Tampere, FI-33101
Finland

HOME PAGE: http://https://sites.google.com/site/juhokanniainen/

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