Exchange Rate Economics: Theories and Evidence

14 The market microstructure
approach to the foreign
exchange market
Up to this point the focus has been on the macroeconomics of exchange rate
behaviour and we have argued,either directly or indirectly,that this focus is a
valuable one. However,there are still important issues to address with respect to
understanding the daily volume of foreign exchange traded globally and how the
price of foreign exchange is actually set in the foreign exchange market. For example,we
noted in Chapter 1 that on a day-to-day basis the current BIS estimate
of the volume of gross trading in foreign exchange markets on a global basis is
approximately $1.2 trillion, 1 86% of which occurs between market makers alone.
Since the total annual world trade flow is around $4 trillion it is clearly difficult
to explain the massive foreign exchange trade in terms of standard macroeconomic
fundamentals and therefore a number of researchers (see,for example,
Frankel and Rose 1995a; Flood and Rose 1999; Lyons 2001) have proposed
using a microeconomic-based modelling approach,namely,a market microstructure
approach. This micro-based approach focuses on an array of institutional
aspects of the foreign exchange market,such as price formation,the matching
of buyers and sellers (i.e. market makers and brokers) and optimal dealer pricing
policies.
As we shall see later,one of the key explanations offered by the microstructural
approach for the huge daily volume in foreign exchange trade is the so-called
‘hot potato’ effect. The idea is that if an initial trade between a customer and a
bank produces an unwanted position for the dealer,she will try to offload this
to another dealer and this process will continue until an equilibrium,where the
initial foreign exchange position is willingly held,is reached. This may be seen
as a form of risk management. The interpretation of high volume has important
policy implications. For example,if,as many conjecture,high volume is a reflection
of speculation some form of tax,such as the Tobin tax of throwing ‘sand in
the wheels’ of international finance,may be the appropriate remedy. But if the
volume reflects risk management the tax would impede this and would therefore be
undesirable.
Garman (1976) introduced the term market microstructure to define ‘momentto-moment
trading activities in asset markets’. O’Hara (1995) gives a more
general finance-based definition: ‘Market microstructure is the study of the process