Constrained liquidity provision in currency markets

(revised January 2024)

Summary

Focus 

The paper examines the role of financial intermediaries in supporting the functioning of the foreign exchange (FX) market. We argue that tighter constraints on the intermediation capacity of dealers, such as higher funding costs and more restrictive value-at-risk (VaR) limits, can lead to increased liquidity costs and affect the efficacy of no-arbitrage conditions. Our study focuses on understanding the impact of these constraints on both the cost and quantity of liquidity provision in the FX market.

Contribution 

This paper provides a framework for measuring the costs of providing liquidity in the FX market. By analysing the triangular relationship between FX spot rates, we introduce two measures of liquidity costs: VLOOP (the deviation of mid-quotes from the triangular relationship) and TCOST (the round-trip transaction cost of triangular arbitrage trades). We also develop a simple and tractable model to study the supply and demand of liquidity in the currency market. Using a range of econometric techniques and a globally representative data set of FX spot trading volumes, we validate the model's predictions by showing a non-linear relationship between the cost and quantity of currency market liquidity.

Findings 

We find that when dealers face tighter constraints on their intermediation capacity, the cost of providing FX liquidity increases disproportionately more relative to trading volume. When the dealer sector is more constrained due to higher funding costs and more restrictive VaR limits, the otherwise strong and positive correlation between the cost and the quantity of FX liquidity provision weakens substantially. Guided by our theoretical framework and by employing various econometric techniques, we show that this result stems primarily from a reduction in the elasticity of liquidity supply, rather than from changes in liquidity demand.

Abstract

We devise a simple model of liquidity demand and supply to deepen the understanding of dealers' liquidity provision in currency markets. Drawing on a globally representative data set on currency trading volumes, we show that at times when dealers' intermediation capacity is constrained the cost of liquidity provision increases disproportionately relative to dealer-intermediated volume. Thus, the otherwise strong and positive relation between liquidity costs and trading volume effectively shrinks to zero when dealers are more constrained. Using various econometric approaches, we show that this result primarily stems from a reduction in the elasticity of liquidity supply, rather than changes in liquidity demand.

JEL classification: F31, G12, G15

Keywords: currency markets, dealer constraints, market liquidity, foreign exchange, liquidity provision