I. Introduction
II. The Structure of Foreign
Exchange Markets
A. Information and Agents
B. Institutions
C. Interbank Trading Options
D. Transparency
III. Direct Trading and Voice Brokers
A. Dealer Behavior
IV. Electronic Brokers
A. Transparency
B. Liquidity
C. Transaction Costs
469
New Economy Handbook
Copyright 2003, Elsevier Science . All rights reserved.
D. The Future of Direct Trading
and Voice Brokers
E. Policy Implications
V. Internet Trading
A. The Emergence of Nonbank
Customer Trading
B. Internet Trading with Banks
C. Possible Scenarios
VI. Summary
A. Web Sites on Trading and
Networks
References and Further Reading
Bid–ask spread Difference between the best buy price (ask) and best sell
price (bid).The initiator of a trade buys at the ask and sells at the lower
bid price. The spread is a measure of transaction costs. The buy price is
also called the “offer.”
Broker Brokers match dealers in the interbank market without being
a party to the transactions themselves and without taking positions
(cf. dealer).
Call market A market where all traders trade at the same time when
called upon.
Counterparty credit risk The risk that the market participant on the other
side of a transaction will default. Due to the large trade sizes in foreign
exchange markets, credit risk is an important issue.
Dealer A person employed by a bank whose primary business is entering
into transactions on both sides of wholesale financial markets and
seeking profits by taking risks in these markets (cf. broker).
Dealer market Market where orders for execution pass to an intermediary
(dealer) for execution.
Interbank market The market where dealers trade exclusively with each
other, either bilaterally or through brokers.
Limit order Order to buy a specified quantity up to a maximum price or
sell subject to a minimum price (cf. market order).
Liquidity Characteristic of a market where transactions do not excessively
move prices. It is also easy to have a trade effected quickly
without a long search for counterparties (“immediacy”). Liquid markets
usually have low bid–ask spreads, high volume, and (relatively) low
volatility.
Market maker Dealer ready to quote buy and sell prices upon request.
The market maker provides immediacy (liquidity services) to the market
and receives compensation through the spread.There is no formal obligation
to quote tight spreads; rather, market making is governed by
reciprocity.
Market order Order to buy (or sell) a specified quantity at the best prevailing
price (cf. limit order).
Order-driven market Market where prices are determined by an order
execution algorithm from participants sending firm buy and sell orders,
which are incorporated into the limit order book (cf. quote-driven or
dealer market).
Order flow Signed flow of transactions. The transaction is given a
positive (negative) sign if the initiator of the transactions is buying
(selling).
Price discovery Determination of prices in a market. Incorporation of
information into prices.
470 Rime
Quote-driven market Refers to a market where market makers post bid
and ask quotes upon bilateral request. In the interbank market, these
prices are on a take-it-or-leave-it basis (cf. order-driven market).
Transparency Ability of market participants to observe trade information
in a timely fashion.
I. INTRODUCTION
The 1990s gave us what might prove to be the two biggest changes in
foreign exchange market structure since World War II: electronic brokers
were introduced into the interbank market in 1992, and in the late 1990s
the Internet became available as a trading channel for customers.What are
the consequences for the market of these innovations? Is there any reason
to believe that these technological developments have influenced the
market in any significant way? Do not dealers in the foreign exchange
market still fulfill their function as liquidity providers and aggregate information
in their price setting? And, do not basic macroeconomic variables
still drive exchange rates, irrespective of trading technology?
In an ideal world with perfect information, these changes to the institutions
of trading probably would not matter that much at the macroeconomic
level. In such a world, exchange rates would be determined by
expectations regarding macroeconomic fundamentals like inflation, productivity
growth, and interest rates. Exchange rates will be efficient asset
prices when all market participants observe these fundamentals and agree
on how they influence exchange rates. Furthermore, provision of liquidity
would be much less risky than in a situation with imperfect information.
However, as empirical evidence has shown all too clearly, models of an ideal
world with perfect information do not hold, at least not for horizons shorter
than a year or so.
The microstructure approach to foreign exchange has made some
promising steps toward solving some of these puzzles (see Lyons, 2001a).
This approach differs from the traditional macroeconomic approach by
allowing for imperfect information and heterogeneous agents and, thereby,
leaving a role for trading institutions as such. In such a world, technological
changes such as the introduction of electronic brokers and Internet
trading may be significant because they change the structure of the market.
A different market structure changes the game played between the
market participants. This may influence information aggregation capabilities
and incentives for liquidity provision and, thereby, different aspects of
market quality like efficiency (price discovery), liquidity, and transac-tion costs. We are interested in understanding market structure because
a well-functioning foreign exchange market is important for the macroeconomy.
This chapter considers the impact of technological advances on
the foreign exchange market by focusing on these properties of market
quality.
The new economy and foreign exchange markets is a vast subject. We
limit ourselves to the two major innovations in trading technology because
trading institutions are an important part of a financial market’s structure.
Furthermore, several studies show that trading is important for the
determination of exchange rates. There is particular focus on a property
of market structure called transparency, i.e., how much of the trading
process market participants can observe. Because trading is an important
determinant of exchange rates, observation of the trading process is
important to enable dealers to set the “correct” exchange rates. On a more
general level, transparency relates to how efficiently dealers can aggregate
information.
There are of course many other uses of information and communication
technology (ICT) that have obviously influenced the markets that we do
not address here. These include information providers such as Reuters
and Bloomberg, computers’ calculation capabilities and the importance
for option trading, and of course network technologies and computers in
general. Two other technological innovations deserving special attention
that we do not consider are the newly started settlement service
(Continuous Linked Settlement), which went live on September
9, 2002, and the netting technology FXNet. The former links all participating
countries’ payment systems for real-time settlement. With such a
system in place in 1974, the famous Bankhaus Herstatt default would
never had happened. FXNet is a technology for netting out gross liabilities.
Both are very important for the handling of counterparty credit
risk.
Sections II and III provide the background for the introduction of electronic
brokers and Internet trading. A brief description and history are
given of the structure of the market prior to these innovations, followed by
some considerations that dealers take into account in their trading. The
trading institutions of the 1980s are referenced to clarify the differences.
Section IV discusses electronic brokers, whereas Section V discusses Internet
trading. Section VI provides a summary.
