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Optimal Transparency in a Dealership Market with an Application to Foreign Exchange

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  • Richard K. Lyons

Abstract

This paper addresses the issue of optimal transparency in a multiple-dealer market. In particular, we examine the question: Would risk-averse dealers prefer ex-ante that signed order flow were observable? We answer this question with the solution to a mechanism design problem. The resulting incentive-efficient mechanism is one in which signed order flow is not observable. Rather, dealers prefer a slower pace of price discovery because it induces additional risk-sharing. Specifically, slower price discovery permits additional trading with customers prior to revelation; this reduces the variance of unavoidable position disturbances, thereby reducing the market making risk inherent in price discovery. We then apply the framework to the spot foreign exchange market in order to understand better the current degree of transparency in that market.

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Bibliographic Info

Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 4467.

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Date of creation: Sep 1993
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Publication status: published as Journal of Financial Intermediation, July 1996, vol. 5, pp. 225-254, withtitle change: "Optimal Transparency in a Dealer Market with an Applicationto Foreign Exchange."
Handle: RePEc:nbr:nberwo:4467

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  1. Richard K. Lyons, 1993. "Tests of Microstructural Hypotheses in the Foreign Exchange Market," NBER Working Papers 4471, National Bureau of Economic Research, Inc.
  2. Garman, Mark B., 1976. "Market microstructure," Journal of Financial Economics, Elsevier, vol. 3(3), pages 257-275, June.
  3. Diamond, Douglas W. & Verrecchia, Robert E., 1981. "Information aggregation in a noisy rational expectations economy," Journal of Financial Economics, Elsevier, vol. 9(3), pages 221-235, September.
  4. Kyle, Albert S, 1989. "Informed Speculation with Imperfect Competition," Review of Economic Studies, Wiley Blackwell, vol. 56(3), pages 317-55, July.
  5. Wolinsky, Asher, 1987. "Information Revelation in a Market with Pairwise Meetings," The Warwick Economics Research Paper Series (TWERPS) 284, University of Warwick, Department of Economics.
  6. Laffont, Jean-Jacques & Maskin, Eric S, 1990. "The Efficient Market Hypothesis and Insider Trading on the Stock Market," Journal of Political Economy, University of Chicago Press, vol. 98(1), pages 70-93, February.
  7. Bray, Margaret M, 1981. "Futures Trading, Rational Expectations, and the Efficient Markets Hypothesis," Econometrica, Econometric Society, vol. 49(3), pages 575-96, May.
  8. Myerson, Roger B, 1986. "Multistage Games with Communication," Econometrica, Econometric Society, vol. 54(2), pages 323-58, March.
  9. Myerson, Roger B. & Satterthwaite, Mark A., 1983. "Efficient mechanisms for bilateral trading," Journal of Economic Theory, Elsevier, vol. 29(2), pages 265-281, April.
  10. Chris J. Leach & Ananth N. Madhavan, . "Price Experimentation and Security Market Structure," Rodney L. White Center for Financial Research Working Papers 20-92, Wharton School Rodney L. White Center for Financial Research.
  11. Biais, Bruno, 1993. " Price Information and Equilibrium Liquidity in Fragmented and Centralized Markets," Journal of Finance, American Finance Association, vol. 48(1), pages 157-85, March.
  12. Mark D. Flood, 1991. "Microstructure theory and the foreign exchange market," Review, Federal Reserve Bank of St. Louis, issue Nov, pages 52-70.
  13. Ho, Thomas S Y & Stoll, Hans R, 1983. " The Dynamics of Dealer Markets under Competition," Journal of Finance, American Finance Association, vol. 38(4), pages 1053-74, September.
  14. Lyons, Richard K., 1990. "Whence exchange rate overshooting: Money stock or flow?," Journal of International Economics, Elsevier, vol. 29(3-4), pages 369-384, November.
  15. Goodhart, Charles, 1988. "The Foreign Exchange Market: A Random Walk with a Dragging Anchor," Economica, London School of Economics and Political Science, vol. 55(220), pages 437-60, November.
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Cited by:
  1. Richard K. Lyons, 1996. "Foreign Exchange Volume: Sound and Fury Signifying Nothing?," NBER Chapters, in: The Microstructure of Foreign Exchange Markets, pages 183-208 National Bureau of Economic Research, Inc.
  2. Richard K. Lyons, 1993. "Tests of Microstructural Hypotheses in the Foreign Exchange Market," NBER Working Papers 4471, National Bureau of Economic Research, Inc.
  3. Vogler, Karl-Hubert, 1997. "Risk allocation and inter-dealer trading," European Economic Review, Elsevier, vol. 41(8), pages 1615-1634, August.
  4. Nicolas Audet & Toni Gravelle & Jing Yang, 2002. "Alternative Trading Systems: Does One Shoe Fit All?," Working Papers 02-33, Bank of Canada.
  5. Victoria Saporta, 1997. "Which Inter-dealer Market Prevails? An analysis of inter-dealer trading in opaque markets," Bank of England working papers 59, Bank of England.

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