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Market liquidity under stress: observations from the FX market

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Abstract

Market liquidity under stress: observations from the FX market BIS Papers No 2 149 Market liquidity under stress: observations from the FX market Francis Breedon, Lehman Brothers Given the thorough exposition of the theoretical aspects of liquidity given elsewhere in the conference, I will focus my remarks on a market perspective to these issues. First, outlining in general how periods of market stress appear from an FX dealing floor, and second looking in detail at whether the euro could be subject to such an event. FX markets under stress Market makers tend to identify two types of stress events in FX markets, the first involving high volatility and high turnover the second high volatility and low turnover. In general, high volatility and high turnover events are good times for market makers, since they can achieve the seemingly contradictory combination of keeping quoted spreads relatively narrow while substantially increasing their profit per trade. This is achieved through higher effective spreads whereby market makers find it easier to “read” incoming trades and so quote accordingly. Examples of this type event include the periodic 10 yen moves of dollar/yen, and the fallout for a developed country currency crisis. Although large trades are difficult to execute in such periods, liquidity in terms of the ability to execute a trade remains, the cost is that effective spreads are wide. High volatility low turnover events are rarer and represent bad times for market makers. These usually occur after a high volatility high turnover event but change in character as the market has lost two-way interest. Despite being able to read future trades, market makers are unable to make money as it is impossible to lay off trades elsewhere. Therefore, these any trades have a disproportionate impact on prices and market makers find themselves on the wrong side of these moves. The reaction is to widen quoted spreads considerably or not quote at all. Although these event are rare, the aftermath of

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