Liquidity Provision in the Foreign Exchange Market

83 Pages Posted: 22 Aug 2018 Last revised: 16 Jan 2019

See all articles by Florent Gallien

Florent Gallien

Swissquote Bank

Serge Kassibrakis

Swissquote Bank

Nataliya Klimenko

University of Zurich

Semyon Malamud

Ecole Polytechnique Federale de Lausanne; Centre for Economic Policy Research (CEPR); Swiss Finance Institute

Alberto Teguia

Rice University, Jesse H. Jones Graduate School of Business, Students

Date Written: July 15, 2018

Abstract

Foreign exchange operates as a two-tiered over-the-counter (OTC) market dominated
by large, strategic dealers. Using proprietary high frequency data on quotes
by the largest foreign exchange dealer banks in the dealer-to-customer (D2C) market,
we find a significant heterogeneity in their behavior. We develop a model of strategic
competition that accounts for this heterogeneity and the two-tier market structure
and allows us to link prices and bid-ask spreads in the D2C and dealer-to-dealer
(D2D) market segments. We use the model to recover dealers' risk aversions and
inventories from their quotes in the D2C segment and construct an endogenous measure
of systemic, non-diversi able risk capturing the cross-sectional liquidity-risk mismatch.
Consistent with the model predictions, we find that liquidity mismatch positively
predicts prices in the D2D market whereas the cross-sectional dispersion in dealer
D2C spreads negatively predicts the level of spreads in the D2D market.

Keywords: Liquidity, Foreign Exchange, OTC markets, Price Impact, Market Power

JEL Classification: F31, G12, G14, G21

Suggested Citation

Gallien, Florent and Kassibrakis, Serge and Klimenko, Nataliya and Malamud, Semyon and Teguia, Alberto, Liquidity Provision in the Foreign Exchange Market (July 15, 2018). Swiss Finance Institute Research Paper No. 18-56. Available at SSRN: https://ssrn.com/abstract=3234406 or http://dx.doi.org/10.2139/ssrn.3234406

Florent Gallien

Swissquote Bank ( email )

Ch. de la Crétaux 33
Gland, Vaud 1196
Switzerland

Serge Kassibrakis

Swissquote Bank ( email )

Ch. de la Crétaux 33
Gland, Vaud 1196
Switzerland

Nataliya Klimenko

University of Zurich ( email )

Plattenstrasse 32
Zürich, CH-8006
Switzerland

Semyon Malamud (Contact Author)

Ecole Polytechnique Federale de Lausanne ( email )

Lausanne, 1015
Switzerland

Centre for Economic Policy Research (CEPR) ( email )

London
United Kingdom

Swiss Finance Institute

c/o University of Geneva
40, Bd du Pont-d'Arve
CH-1211 Geneva 4
Switzerland

Alberto Teguia

Rice University, Jesse H. Jones Graduate School of Business, Students ( email )

Houston, TX
United States

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