The relative merits of algorithmic and high-frequency trading are most often discussed in the context of equity markets. In this post, we look at the foreign exchange (FX) spot market. The growth of algorithmic and high-frequency trading in this market has introduced new entrants as well as new complexities and challenges that have important implications for the liquidity landscape and the risk management framework in FX markets. This post focuses narrowly on an important measure of FX market efficiency, absence of arbitrage opportunities, to discuss the improvements in this particular measure of efficiency that have coincided with significant growth in algorithmic and high-frequency trading.See also:
The FX spot market is often considered one of the deepest and most liquid markets in the world; the Bank for International Settlements (BIS) estimates global average daily volume of $2.0 trillion in April 2013. Activity is dominated by trading in the three major currencies—the U.S. dollar (USD), the euro (EUR), and the Japanese yen (JPY). While there’s a broad diversity of players in the FX spot market—including corporations, official institutions, and pension funds—the latest data show that activity is most concentrated among the large FX dealers and other financial institutions. Indeed, dealers are often the conduit through which nondealers access the market, for example, via prime brokerage relationships. The FX spot market is an over-the-counter market and differs importantly from other liquid markets like equities or futures, which are exchange traded and therefore feature a centralized counterparty. FX spot trades, in contrast, are bilateral transactions that rely on credit arrangements between the two parties involved, which means that each participant only sees, and can act on, quotes posted by counterparties with whom a bilateral credit arrangement is in place. Accordingly, there’s no concept of a universal best bid and offer price, as is the case with U.S. equity markets....MORE
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