Uninformed yet Consequential: Liquidity Shocks in FX Markets

Abstract

We study how retail liquidity shocks impact prices and volumes in the foreign exchange (FX) spot market. We model risk-averse dealers' accumulation of inventory under asymmetric information and incomplete offset across retail clients. Our model predicts that retail liquidity shocks result in inventory imbalances that are transmitted to the inter-dealer segment, increasing price volatility and trading volumes. Using month-end settlement breaks to instrument for uninformed order flow, we empirically validate these predictions: a one-standard-deviation rise in retail net volume increases volatility by 12-22% and inter-dealer volume by 10%, indicating that liquidity-driven demand interacts with intermediary constraints to determine asset prices.

Keywords: price volatility, liquidity shocks, dealer constraints, market segmentation, financial frictions, risk-bearing capacity JEL classification: F31, G12, G15, G23

JEL Classification: F31, G12, G15