Forex markets and the euro – a symposium

(discussant: Kenneth Rogoff)

1) Analysis of Spreads in the Dollar/Euro and Deutschemark/Dollar Foreign Exchange Market

Authors: Charles Goodhart, Ryan Love, Richard Payne and Dagfinn Rime

We compute bid-ask spreads for the dollar/euro exchange rate market and find them to be substantially larger than their Deutsche mark counterparts before introduction of the euro. We show that larger percentage spreads are not explained by volatility, trade intensity, and other standard explanatory variables in our data sets. But we also show that spreads have not increased in terms of the unit (“pip”) used in exchange rate quotations to the fourth decimal point. Since the euro is worth about two marks, and was initially worth more than a dollar, this finding suggests that larger percentage spreads reflect the more pronounced “granularity” of quoting conventions in euro-dollar rather than dollar-mark trading. We discuss whether mandating quotations to the fifth decimal point might be advisable, and conclude that such a policy might but need not increase the foreign exchange market’s liquidity.

2) Features of the Euro’s Role in International Financial Markets

Authors: Carsten Detken and Philipp Hartmann

Three years after the euro’s introduction, we discuss its role in foreign exchange and international debt securities markets on the basis of a comprehensive set of data sources. In spot foreign exchange markets the euro’s role resembles that of the Deutsche mark, with a dominant position in the Nordic and several Central European countries. Transaction costs in the important dollar-euro market are larger than they used to be for dollar-mark, but the same does not hold for any other major spot market. We discuss how this phenomenon may be explained by persistence of bid-ask quoting conventions in this market in the face of changed nominal parities. We show a notable reduction in euro swap trading and explain it, inter alia, with the elimination of dollar swaps meant to hedge exchange rate risk between currencies now subsumed in the euro. We observe strong growth of euro-denominated debt securities, while international euro bond investments are stable at the level of the “synthetic euro” aggregate of legacy currencies.

3) Theoretical Perspective on Euro Liquidity

Author: Richard K Lyons

I provide theoretical perspective on recent findings of increased transaction costs in the new dollar-euro market relative to the prior dollar-mark market, and assess the welfare significance of this drop in liquidity. In theory, transaction costs arise from information disadvantage costs, inventory management costs, and other marketmaking costs (e.g., order-processing costs). A review of theoretical reasons for the underlying costs to be rising can allows one to discriminate among hypotheses for the liquidity drop. New data on public trades support a customer liquidity hypothesis, based on the idea that the ultimate providers of liquidity in this market are customers rather than marketmakers. However, the hypothesis is not consistent with the totality of the evidence, and I discuss how a combination of various mechanisms can increase transaction costs and the FX market’s information efficiency.