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Summary
Focus
The paper focuses on the role of financial intermediaries in supporting the functioning of the foreign exchange (FX) market. We argue that the capacity of intermediaries to provide liquidity is tied to their ability to absorb risk, which affects the cost of liquidity provision and the FX market's overall functioning. We examine two key questions: (i) do intermediaries' constraints increase the cost of market liquidity, and (ii) does liquidity provision become less elastic when constraints on intermediaries tighten?
Contribution
This paper provides a framework for measuring the costs of providing liquidity in the FX market. By analysing the triangular relationship between FX spot rates, we introduce two measures of liquidity costs: VLOOP (the deviation of mid-quotes from the triangular relationship) and TCOST (the round-trip transaction cost of triangular arbitrage trades). We study how intermediation constraints affect these costs. We document a novel non-linear relationship between the cost of liquidity provision and dealer-intermediated volume. Lastly, we also provide a simple and tractable model to explain these empirical findings.
Findings
We find that both measures are economically significant. However, TCOST is an order of magnitude larger than VLOOP. We also find a co-movement between the two measures over time, albeit with low average correlation. When dealers face intermediation constraints, their liquidity provision becomes more expensive, and their liquidity supply becomes less elastic (ie the correlation between liquidity costs and volumes decreases). The results emphasize the impact of dealer constraints on both the cost and quantity of foreign exchange liquidity provision.
Abstract
We study dealers' liquidity provision in the currency market. We show that at times when dealers' intermediation capacity is constrained their cost of liquidity provision increases disproportionately relative to dealer-provided volume. As a result, the elasticity of dealers' liquidity provision drops by at least 80% relative to periods when they are unconstrained. We identify constrained periods based on leverage ratios, Value-at-Risk measures, credit default spreads, and debt funding costs. We interpret our novel empirical findings within a parsimonious model that sheds light on the key mechanisms of how liquidity provision by dealers tends to weaken when intermediary constraints are tightening.
JEL classification: F31, G12, G15
Keywords: currency markets, dealer constraints, market liquidity, foreign exchange, liquidity provision
