Optimal Transparency in a Dealership Market with an Application to Foreign Exchange

48 Pages Posted: 7 Nov 2007 Last revised: 17 Sep 2022

See all articles by Richard K. Lyons

Richard K. Lyons

University of California, Berkeley; National Bureau of Economic Research (NBER)

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Date Written: September 1993

Abstract

This paper addresses the issue of optimal transparency in a multiple-dealer market. In particular, we examine the question: Would risk-averse dealers prefer ex-ante that signed order flow were observable? We answer this question with the solution to a mechanism design problem. The resulting incentive-efficient mechanism is one in which signed order flow is not observable. Rather, dealers prefer a slower pace of price discovery because it induces additional risk-sharing. Specifically, slower price discovery permits additional trading with customers prior to revelation; this reduces the variance of unavoidable position disturbances, thereby reducing the market making risk inherent in price discovery. We then apply the framework to the spot foreign exchange market in order to understand better the current degree of transparency in that market.

Suggested Citation

Lyons, Richard K., Optimal Transparency in a Dealership Market with an Application to Foreign Exchange (September 1993). NBER Working Paper No. w4467, Available at SSRN: https://ssrn.com/abstract=480255

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