Microstructure effects, bid–ask spreads and volatility in the spot foreign exchange market pre and post-EMU
Introduction
This study uses a unique and rich foreign exchange (FX) dataset of global inter-dealer electronic transactions to examine microstructural effects in the spot foreign exchange market. This dataset allows us to shed new light on the debate surrounding the observations that trading volumes have fallen and bid–ask spreads have widened in inter-dealer spot FX markets following European Monetary Union (EMU). Our work provides a more detailed account of the changes that actually occurred at this time, because our data is more comprehensive than has previously been available. However, this is more than just an empirical study. We also introduce new theoretical explanations and new methodologies to this debate. These enable us to demonstrate that much of the change in bid–ask spreads and some of the change in price volatility can be explained by four technical features of high-frequency data, namely price discreteness, price clustering, the time elapsed between sample periods and the time-gap between successive traded or quoted prices. This explanation is in contrast to the hypothesis of market maker response to exogenous changes in volume proposed by Hau et al., 2000, Hau et al., 2002.
It is widely acknowledged that volumes decreased in the inter-bank spot FX market after EMU (see BIS, 2001). It also became increasingly accepted that the EUR/USD bid–ask spread widened at the same time. Hau et al., 2000, Hau et al., 2002 suggested that lower FX trading volumes and wider bid–ask spreads observed since EMU, are both due to a decrease in “market transparency”. The latter hypothesis centers on the idea that the availability of fewer currency pairs after EMU makes risk management harder to implement. Hau et al. suggest that this causes market makers to quote wider bid–ask spreads, which in turn results in lower volumes.
One part of our argument has been made previously by Goodhart, Love, Payne, and Rime (2002). They argued that “price granularity” could account for the observed fall in inter-dealer bid–ask spreads and that reduced volumes are a coincidence due to unrelated structural changes in the industry. What they call “price granularity” is more usually called “price discreteness” in the literature. Price discreteness means that prices are not an infinite number of digits long, but rather they are truncated to a small number of digits. In the case of the FX market, exchange rates are specified to five digit accuracy by convention. The Goodhart et al. (2002) view was also echoed by Detken and Hartmann (2002) who used lower frequency data. We believe that Goodhart et al. (2002) were broadly on the right track, but they did not uncover the full story. In addition, Goodhart et al. (2002) only focused on the USD/DEM and EUR/USD exchange rates. We are able to analyze many more currency pairs over the period of EMU convergence.
The price clustering and time arguments that we present are new to this debate. Price clustering refers to the fact that traders may not use all available exchange rates uniformly. In practice, rates ending in 0 or 5 tend to be used more than other rates. The time elapsed between the sample periods is important for a very obvious reason— price levels can differ radically if data is sampled from periods that are far apart in time. On the other hand, the time-gap between successive individual prices is also important because it allows these prices to drift apart. When the successive prices are transaction prices, this effect increases volatility. When they are successive bid and ask prices, the bid–ask spread is increased. These new perspectives reveal that volumes and bid–ask spreads are not unrelated as Goodhart et al. (2002) had argued, but are in fact inextricably interwoven. However, our arguments suggest the opposite causality to that proposed by Hau et al., 2000, Hau et al., 2002. In short, we find that smaller volumes cause larger bid–ask spreads for technical reasons to do with measurement, whereas Hau et al., 2000, Hau et al., 2002 had argued that larger bid–ask spreads had caused smaller volumes due to trader behavior.
The remainder of this paper is organized as follows. Section 2 discusses the importance of price discreteness and price clustering and reviews that literature. Section 3 similarly explores the role of time and duration. Section 4 reviews market structure and our unique dataset, while Section 5 discusses the empirical methodology. Section 6 presents the results and Section 7 concludes.
Section snippets
The importance of price discreteness and price clustering
Prices move in discrete units. The exact size of these discrete units may be imposed by a regulator or an exchange, or it may arise as a market convention. Price discreteness is clearly important for bid–ask spreads because the minimum price increment, or “tick size”, places a lower bound on the size of the bid–ask spread. It also determines volatility since it determines the minimum increment by which price can change.
Gottlieb and Kalay (1985) found that “…the variance and…the higher order
The role of time and duration
Price levels can move substantially when there is a lengthy interval between the periods being studied. This is consistent with the idea of price being a random walk with drift, whereby drift components grow to different levels over time. The price level is an important factor in computing both the bid–ask spread and price volatility because both are calculated as a percentage of the price level. If price discreteness and clustering cause minimum bid–ask spreads or the price increments to be
Market structure and data
There is one further feature of the inter-dealer spot FX market that is important in the determination of volatility, bid–ask spreads and especially volumes. This is cross exchange rate arbitrage and the associated phenomenon of vehicle currencies. The best way to explain this feature is by example. Consider an exchange rate system with three currencies: A, B and C. This gives three exchange rates: A / B, A / C and B / C. Suppose an exogenous shock causes A / C to rise. If there is no change in the
Empirical methodology
The first part of the empirical analysis consists of a comprehensive table of summary statistics which provides evidence of exchange rate behavior, in terms of volume, volatility and bid–ask spreads. It also reveals the price discreteness properties of each rate and how the average time-gap between trades has changed. Subsequently, we consider whether changes in currency levels could have contributed to the observed changes. Deeper investigation of data characteristics involves comparing the
Price granularity, bid–ask spreads, volume and volatility
Table 1, Table 2, Table 4 present the summary statistics for the spot FX data from EBS. These table presents a series of variables that were used by Goodhart et al. (2002) to evaluate ‘price granularity’ as a source of wider bid–ask spreads in the EUR/USD compared with the USD/DEM, using data from Reuters 2000-2. Price granularity is the same concept as price discreteness. As in Goodhart et al. (2002), we compute series for percentage bid–ask spreads and for ‘pip’ bid–ask spreads.3
Conclusions
This article set out to document and explain the changes in bid–ask spreads and in volatility in five currency-pairs between pre-EMU and post-EMU periods. The data used shows that volatility fell for all exchange rates, while some bid–ask spreads widened and others narrowed. Four distinct potential explanatory market microstructure factors for these changes were explicitly considered: price discreteness; price clustering; the inter-temporal shift in currency value; and the time-gap between
Acknowledgements
We thank EBS for providing the data for this research. We are grateful for the comments and suggestions received from participants at the Global Finance Conference, 2005, held at the Trinity College Dublin, and at seminars presented at the ICMA Centre, University of Reading, at the Judge Business School, University of Cambridge and at the University of Wales, Swansea.
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