The Future of the Foreign Exchange Market

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The Future of the Foreign Exchange Market

Abstract
This paper addresses the future of the foreign exchange market using two organizing(and provocative) ideas. One pertains to the market’s institutional structurthe other to its information structure. The first organizing idea is that thestructure of currency markets is driven primarily by the management of credit risk. This contrasts with drivers identified by microstructure theory (such as management of market risk, attenuation of asymmetric information, and entry barriers). The second organizing idea is that price variation in spot currency markets is driven primarily by dispersed information. This too contrasts with the orthodox view, under which exchange rates are determined from public information.

The Future of the Foreign Exchange Market

This paper addresses the future of the foreign exchange market using two organizing (and provocative) ideas. At the risk of jumping the gun, let me state them right off:

(1) Market Structure: Current organization of the largest spot currency markets is driven primarily by the management of credit risk, as opposed to drivers identified in microstructure theory (such as management of market risk, attenuation of asymmetric information, and entry barriers).

(2) Information Structure: Price variation in spot currency markets is drivenprimarily by dispersed information, as opposed to the orthodox assumption of public information.

Both ideas are vital to understanding the foreign exchange (FX) market’s future evolution, as we shall endeavor to show, :-

* Consider the first of these ideas and why I consider it provocative. (Whether it is true is addressed in the following section.) This requires some perspective on the field of microstructure finance. Market design is a central issue within this field, and, importantly, it is through the lens of microstructure finance that people address questions of market structure. Yet the field pays little attention to credit risk. It is focused instead, broadly speaking, along three main lines. The first line, predating even the “microstructure” label, borrows liberally from the field of industrial organization; emphasis in this line is on marketmaker cost structures, departures from perfect competition, and barriers to entry. The second line emerged in the 1970s and focuses on how market makers manage market risk (referred to as the inventory control).

* For everyday functioning of FX markets, this type of information is not terribly plausible, which makes private information models of FX trading naturally provocative. It is only when one considers another, complementary type of non-public information, namely dispersed information (about, for example, imports/exports, hedging demands, or risk preferences) that the notion of information aggregation in FX markets becomes less provocative.

* Addressing the FX market using these two organizing ideas has several advantages. First, it allows a framing of the future-of-FX-markets question as something larger than a purely micro-institutional question.

* This is not to suggest that the institution dimension is not important in its own right. But macroeconomists (i.e., most people working in exchange rate economics) consider the institutional future of the FX market rather uninteresting. By introducing the second idea we can link both perspectives—micro and macro. Second, when the two ideas are treated jointly, one can appreciate their strong interaction. A later section of the paper addresses this “synthesis” and its implications for the future.

* Finally, these two organizing ideas provide a basis for understanding how FX markets differ from equity markets. This is valuable, particularly in a volume like this, since equity markets garner the lion’s share of attention in discussions of the future of securities markets. Though organizing this paper around two core ideas has advantages, it naturally also has...
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