Exchange Rate Economics: Theories and Evidence

346 Market microstructure approach
means the trading process in the foreign exchange market will be less informative
than in other markets.
The agents within banks who conduct trade are referred to as market makers,
so-called because they make a market in one or more currencies by providing bid
and ask spreads for the currencies. The market makers can trade for their own
account (i.e. go long or short in a currency) or on behalf of a client,a term which
encompasses an array of players from central banks,to financial firms and traders
involved in international trade. A foreign exchange broker on the other hand
does not trade on her own behalf but keeps a book of market makers limit orders
(orders to buy/sell a specified quantity of foreign exchange at a specified price)
from which she,in turn,will quote the best bid/ask rates to market makers. The
latter are referred to as the brokers’ ‘inside spread’. The broker earns a profit by
charging a fee for their service of bringing buyers and sellers together. Recently,
various automated brokerage systems have become popular and one of these is
considered in more detail in Section 14.4.2. In sum,then,the foreign exchange
market may be thought of as a multiple dealer market.
As Flood (1991) notes,the interbank market may be described as a decentralised,
continuous,open bid,double auction market,while the brokered market is a quasicentralised,continuous,limit
book,single auction market. These terms have the
following meaning. In the microstructural literature the degree of centralisation of
a market is important because it can have an effect on market efficiency. In centralised
markets agents trade on the basis of publicly quoted prices and all traders
have access to the same trading opportunities. In contrast,a decentralised market
is one in which price quotes and transactions are conducted in private amongst
agents. It is usually argued that there are efficiency gains from having centralised
prices. This follows if it is assumed that trips are costly. With a centralised market
N traders would require N trips compared to a decentralised market where the N
agents have to negotiate bilaterally leading to a total of N(N-1)/2 trips. The decentralised
nature of the foreign exchange market would therefore seem to imply an
efficiency loss. However,there are other potential efficiency gains from having
such a market structure.
The foreign exchange market is referred to as a continuous market in the sense
that trade occurs at its own pace,with transactions being processed as they arrive.
In contrast,the kind of market featured in most microeconomic models is a call
market in which the Walrasian auctioneer calls out a series of prices and receives
buy/sell orders at each price. Transactions are then concluded at a price where the
quantities supplied and demanded are equal. The distinction between these two
kinds of markets is referred to as the degree of temporal consolidation. In call markets
trading occurs at pre-appointed times (the calls) with arriving orders retained until
the next call. In continuous markets trading occurs at its own pace.
Theoretical work (see,for example,Hahn 1984 and Negishi 1962) indicates
how the degree of temporal consolidation can affect the performance of a market.
For example,with continuous trading,transactions conducted at the start of the
trading day can cause shifts in supply and demand which ultimately affect the prices
of later transactions. So it is possible for continuous trading to alter allocations,