The Future of the Foreign Exchange Market

This paper addresses the future of the foreign exchange market using two organizing (and provocative) ideas:

• — 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).

• — Information structure. Price variation in spot currency markets is driven primarily by dispersed information, as opposed to the orthodox assumption of public information.

Both ideas are vital to understanding the future evolution of the foreign exchange (FX) market, as I endeavor to show in this paper.

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 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 focuses instead on 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 market maker 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 line). The third line emerged in the 1980s and focuses on how market makers respond to informational disadvantages (the asymmetric information line).¹ Given the field's structure, it is not surprising that researchers have looked for drivers of structure along these three lines. In none of them does credit risk play a central role, however, leaving management of credit risk largely overlooked.²

Consider now the second of the two organizing ideas and why it too is provocative. Every macroeconomic model in the vast literature on exchange rates is set within a rather special information environment, namely, one characterized by the presence of public information only. In these models, exchange rates are determined by the public arrival of macroeconomic news (about interest rates, inflation rates, and so forth). Because this information is publicly available, the trading process (or, more specifically, order flow) is not needed to induce price movement—this information is impounded in price directly and instantaneously.³ Ask a macroeconomist whether he believes there is private information in the foreign exchange market, and he will answer no. What he probably has in mind is inside information about future variables, like interest rates, in the hands of one or a few individuals ("concentrated" private information). 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 nonpublic information, namely dispersed information (about, for example, imports and 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 the question of the future of FX markets to be framed as something larger than a purely micro institutional question. This is not to suggest that the institutional dimension is not important in its own right. But macroeconomists (that is, most people working in exchange rate economics) consider the institutional future of the FX market rather dull. By introducing the second idea, one 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.

Although organizing this paper around two core ideas has advantages, it also has disadvantages. The two ideas allow us to drill deeper into key issues, but...