Liquidity provision in the overnight foreign exchange market

of customers is weakly exogenous to the price. This is reasonable, given that we expect
Financial customers to “push” the market utilizing private information. The fact that the
effect from their trading is positive and persistent is an indication that there indeed is an
information effect. The trend enters significantly in the price equation for the Financial
customers, but not for the Non-Financial (restricted to zero). Engle and Yoo (1991) suggest
that the trend captures other unobservable variables. If the trading of the Financial
customers are partly driven by information that has not yet reached the market, while
the Non-Financial customers act as liquidity providers, we would expect that the trend
should enter the price equation with the position of Financial customers but not in the
price equation of the Non-Financial customers. The intuition for the weak exogeneity
of the position of Non-Financial customers is that the banks “pick” price-quantity
combinations along their supply curve. One can think of this as if Non-Financial customers
placed a limit-order schedule in the market in the morning. Weak exogeneity
allows us to run single-equation error correction models with contemporaneous flow as
an exogenous variable. We return to this below.
4.2 Regressing exchange rate changes on customers’ flows and changes
in interest rates
Having established that there is a long-term relation between the net positions of customers
(accumulated flow) and the exchange rate, we proceed to look at the relation
between net flows (changes in net positions) and changes in the exchange rate. The
cointegration analysis established evidence of liquidity provision in the long run. By
studying short-run dynamics we can say something about liquidity provision overnight.
In all regressions, we include the error correction term from the cointegration anal-
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