Theoretical perspective on euro liquidity

Author: Lyons R.K.

Source: Economic Policy, Volume 17, Number 35, October 2002 , pp. 572-597(26)

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Abstract:

I provide theoretical perspective on recent findings of increased transaction costs in the new dollar–euro market relative to the prior dollar–mark market, and assess the welfare significance of this drop in liquidity. In theory, transaction costs arise from information disadvantage costs, inventory management costs, and other market–making costs (e.g., order–processing costs). A review of theoretical reasons for the underlying costs to be rising can allow one to discriminate among hypotheses for the liquidity drop. New data on public trades support a customer liquidity hypothesis, based on the idea that the ultimate providers of liquidity in this market are customers rather than market–makers. However, the hypothesis is not consistent with the totality of the evidence, and I discuss how a combination of various mechanisms can influence transaction costs and the FX market’s information efficiency.

Language: English

Document Type: Research article

Affiliations: 1: U.C. Berkeley

Publication date: 2002-10-01