Liquidity provision in the overnight foreign exchange market

the Central Bank.
We use the theory of market making to characterize what to expect of a liquidity
providing group of market participants, if one exists. There are two characteristics of
a liquidity provider: (a) The net currency position of the liquidity provider will be
negatively correlated with the value of the currency; and (b) The trading of the liquidity
provider will be result of passively matching others’ demand and supply.
We have presented several findings supporting the proposition that Non-Financial
customers are the main liquidity providers in the Swedish market. First, we confirm
that there is a positive correlation between the net purchases of currency made by Financial
customers and changes in the exchange rate. Thus, when Financial investors
buy SEK, the SEK tends to appreciate. The correlation becomes stronger as we lower
the frequency. These findings are consistent with the results of Froot and Ramadorai
(2002) and Fan and Lyons (2003).
Furthermore, we find that the positive correlation between net purchases of currency
of Financial customers and the exchange rate is matched by a negative correlation between
the net purchases of Non-Financial customers and changes in the exchange rate.
The coefficient is not only similar to the one of Financial customers in absolute value,
but is also very stable. These findings lead us to conclude that Non-Financial customers
fulfill requirement (a) above, while Financial customers do not.
Second, we also find that requirement (b), that the liquidity providers passively
match changes in the demand and supply of others, is supported for the Non-Financial
customers. We find that the trading of Financial customers and Market making banks
can forecast the trading of Non-Financial customers, but not the other way. We interpret
this as evidence that the Non-Financial customer group is not the active part in trading.
Third, in our cointegration analysis we find the two previous points supported for
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