Liquidity Provision in the Foreign Exchange Market

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