Exchange Rate Economics: Theories and Evidence

Market microstructure approach 347
the process of price discovery and the ultimate equilibrium price relative to the
Walrasian ‘call’ equilibrium. To set against this,however,the periodic batching of
orders that occur in a call market can also have a deleterious effect on investors,
since the difference in time between the placement and settlement of orders can
impose real costs on investors. Therefore in such a market agents may be prepared
to pay a liquidity premium to trade immediately. Also the lack of continuity between
calls means that the flow of information is not continuous and this may introduce
uncertainty into the period between calls. Lyons (2001) argues that the extent to
which trades are actually ‘out of equilibrium’ or not depends on the amount of
information available to the dealer. For example,if the dealer is not initially sure
what the buyer–seller imbalance is,then rational trade can occur in the transition
to the new equilibrium (i.e. the dealer is unable to trade using all of the information
available to the Walrasian auctioneer).
In sum,a trade-off exists between the allocational efficiency of a Walrasian call
system and the informational efficiency of a continuous market. As Flood (1991)
notes,it is unclear if the microstructure of the foreign exchange market represents
a globally optimal balance of these advantages.
As noted earlier,the interbank market is referred to as an open bid market,
while the brokered part of the market is a limit book market. The terms open bid
and limit book refer to ways in which price is communicated. The extreme form of
open bid is the open outcry system of futures exchanges where buy/sell offers are
communicated to all agents in the market. The interbank market approximates this
since any agent can contact any bank at any time to obtain a price quote. Of course,
the bilateral nature of the negotiations means that not all market participants can
be simultaneously informed of the current quotes of a market maker. This,of
course,can introduce the possibility of genuine arbitrage possibilities if,say,two
market makers can be found whose bid–ask spread does not overlap.
The limit order books 4 of brokers may also impart another layer of inefficiency
into the foreign exchange market since only the ‘best’ bid–ask spreads of brokers
are revealed to market makers. Knowledge of the concealed limit order would be
of potential value to market makers since an unbalanced book would suggest a
future price move in one direction or other. The potential search process of an
agent searching for the best quote in the foreign exchange market means the agent
is prepared to pay a premium to avoid constant access to a counterparty. The
existence of this premium,however,suggests that the foreign exchange market
does not provide as an efficient means of communicating prices as a fully centralised
market.
The classifications single and double auction refer to the nature of the quoted
prices. In a single auction market prices are specified either to buy or sell,whereas
in a double auction market participants provide both bid and ask prices. In the
foreign exchange market the market makers provide the double auction prices
while the broker tries to aggregate single auction quotes into inside spreads. As
Flood (1991) notes,this issue is related to the degree of centralisation in a market.
Since market makers are absent in a single auction market this,combined with
transaction costs,produces a tendency towards centralisation of price information,