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1 June 2015 CFA Institute Journal Review

The Cost of Liquidity in the FX Market (Digest Summary)

  1. Marc L. Ross, CFA

To measure the cost of trading in the foreign exchange market, the authors create a limit order book from 17 different available trading sources. They find that the cost of trading in this market varies widely.

What’s Inside?

Foreign exchange trading liquidity is difficult to gauge. Market opacity and the lack of a robust toolkit to evaluate it make measurement a challenging endeavor. The authors create a limit order book from 17 different trading sources for the period 1 January 2013–31 March 2013. From this limit order book, trading cost, liquidity, and execution are examined.

How Is This Research Useful to Practitioners?

Pricing practices in the foreign exchange market have been inconsistent, which is demonstrated by what appear to be uncompetitive bids as measured by subadvisers’ trading records. Spotty and inconsistent regulation seems to perpetuate this opacity. Impetus for change is manifest in a body of case law on the subject as well as demand from institutional investors for process improvements that would lower costs and preserve alpha—that is, excess return. More parties are issuing mandates for best execution that would address the cost issue directly. Finally, changes in market structure and growth in trading managed through more powerful mathematical and computer processes are drivers as well.

The authors add to the growing debate with their evaluation of trading costs. The methodology and analysis offer an unprecedented level of transparency. It appears promising for the pursuit of better evaluations of market conditions and liquidity cost. The authors’ findings point to the potential for large cost savings through increased efficiency.

Investment managers would benefit from a greater understanding of the effect of currency transaction mispricing on portfolio returns. A sound methodology to control such costs is critical.

How Did the Authors Conduct This Research?

The authors’ findings are informed by a brief review of the history of foreign exchange trading mispricing as well as by the construction of a consolidated limit order book using liquidity information from numerous data sources, tradable quotes, and a cost analysis of trades. The data are collected for a three-month period between January and March 2013 from 17 different sources. The research considers currency pairs, time, and order size.

The authors start by quantifying transaction costs in the overall market, taking into account numerous deal sizes, times of day to study trading frequency, and multiple market conditions. The object of their analysis is the activity of five major and six minor currency pairs over a three-month period. They review a limit order book for each currency pair that is consolidated from trading data supplied by banks and electronic communication networks.

Both the consolidated book and a synthetic book—itself created from best dealer quotes—are used to study liquidity within foreign exchange trading. Liquidity costs and “all-in” costs—that is, the total costs of an institutional equity transaction—are closely linked. Comparing the trades of the 10 most active equity trading firms, the authors find a great disparity between trading at the average trading cost ($13.8 million) and the most disadvantaged trading cost ($40.8 million).

A separate but similar analysis considers pre-trade information and the impact of the 2014 FIFA World Cup on regional and global currency markets and trading volume. Activity before, during, and after select games provides a forum to illustrate liquidity cost, depth of trading book, and forward-looking volatility calculations.

Abstractor’s Viewpoint

With the expansion and increased interconnectedness of global financial markets comes greater complexity as well as demand from market participants for increased transactional transparency. Such a dearth of clarity has been chronic in the pricing of foreign exchange transactions. The authors create and test a trade cost analysis model to assess the level of opacity and the potential for savings, which has been sorely lacking, in this market. Excessive foreign exchange trading costs detract from portfolio performance. The measurement of such costs and an understanding of how best to mitigate them deserve portfolio managers’ attention.

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