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Constrained Liquidity Provision in Currency Markets

Author

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  • Huang, Wenqian
  • Ranaldo, Angelo
  • Schrimpf, Andreas
  • Somogyi, Fabricius

Abstract

We devise a simple model of liquidity demand and supply to deepen the understanding of dealers’ liquidity provision in currency markets. Drawing on a globally representative data set on currency trading volumes, we show that at times when dealers' intermediation capacity is constrained the cost of liquidity provision increases disproportionately relative to dealer-intermediated volume. Thus, the otherwise strong and positive relation between liquidity costs and trading volume effectively shrinks to zero when dealers are more constrained. Using various econometric approaches, we show that this result primarily stems from a reduction in the elasticity of liquidity supply, rather than changes in liquidity demand.

Suggested Citation

  • Huang, Wenqian & Ranaldo, Angelo & Schrimpf, Andreas & Somogyi, Fabricius, 2024. "Constrained Liquidity Provision in Currency Markets," CEPR Discussion Papers 18776, C.E.P.R. Discussion Papers.
    • Handle: RePEc:cpr:ceprdp:18776
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    Keywords

    Currency markets; Liquidity provision; Market liquidity;
    All these keywords.

    JEL classification:

    • F31 - International Economics - - International Finance - - - Foreign Exchange
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G15 - Financial Economics - - General Financial Markets - - - International Financial Markets

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