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Rise of the machines: algorithmic trading in the foreign exchange market

Author

Listed:
  • Alain P. Chaboud
  • Benjamin Chiquoine
  • Erik Hjalmarsson
  • Clara Vega

Abstract

We study the impact that algorithmic trading, computers directly interfacing at high frequency with trading platforms, has had on price discovery and volatility in the foreign exchange market. Our dataset represents a majority of global interdealer trading in three major currency pairs in 2006 and 2007. Importantly, it contains precise observations of the size and the direction of the computer-generated and human-generated trades each minute. The empirical analysis provides several important insights. First, we find evidence that algorithmic trades tend to be correlated, suggesting that the algorithmic strategies used in the market are not as diverse as those used by non-algorithmic traders. Second, we find that, despite the apparent correlation of algorithmic trades, there is no evident causal relationship between algorithmic trading and increased exchange rate volatility. If anything, the presence of more algorithmic trading is associated with lower volatility. Third, we show that even though some algorithmic traders appear to restrict their activity in the minute following macroeconomic data releases, algorithmic traders increase their provision of liquidity over the hour following each release. Fourth, we find that non-algorithmic order flow accounts for a larger share of the variance in exchange rate returns than does algorithmic order flow. Fifth, we find evidence that supports the recent literature that proposes to depart from the prevalent assumption that liquidity providers in limit order books are passive.

Suggested Citation

  • Alain P. Chaboud & Benjamin Chiquoine & Erik Hjalmarsson & Clara Vega, 2009. "Rise of the machines: algorithmic trading in the foreign exchange market," International Finance Discussion Papers 980, Board of Governors of the Federal Reserve System (U.S.).
  • Handle: RePEc:fip:fedgif:980
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    References listed on IDEAS

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    Cited by:

    1. Aitken, Michael & Cumming, Douglas & Zhan, Feng, 2015. "High frequency trading and end-of-day price dislocation," Journal of Banking & Finance, Elsevier, vol. 59(C), pages 330-349.
    2. Benos, Evangelos & Sagade, Satchit, 2012. "High-frequency trading behaviour and its impact on market quality: evidence from the UK equity market," Bank of England working papers 469, Bank of England.
    3. Michael R. King & Carol Osler & Dagfinn Rime, 2011. "Foreign exchange market structure, players and evolution," Working Paper 2011/10, Norges Bank.
    4. Alsayed, Hamad & McGroarty, Frank, 2012. "Arbitrage and the Law of One Price in the market for American depository receipts," Journal of International Financial Markets, Institutions and Money, Elsevier, vol. 22(5), pages 1258-1276.
    5. Menkveld, Albert J., 2013. "High frequency trading and the new market makers," Journal of Financial Markets, Elsevier, vol. 16(4), pages 712-740.
    6. repec:wsi:qjfxxx:v:02:y:2012:i:03:n:s2010139212500140 is not listed on IDEAS
    7. Scholtus, Martin & van Dijk, Dick & Frijns, Bart, 2014. "Speed, algorithmic trading, and market quality around macroeconomic news announcements," Journal of Banking & Finance, Elsevier, vol. 38(C), pages 89-105.
    8. King, Michael R. & Osler, Carol L. & Rime, Dagfinn, 2013. "The market microstructure approach to foreign exchange: Looking back and looking forward," Journal of International Money and Finance, Elsevier, vol. 38(C), pages 95-119.
    9. O'Connor, James & Wackett, James & Zammit, Robert, 2011. "The use of foreign exchange markets by non-banks," Bank of England Quarterly Bulletin, Bank of England, vol. 51(2), pages 119-126.
    10. Rod Cross & Victor Kozyakin, 2012. "Fact and Fiction in FX Arbitrage Processes," Working Papers 1211, University of Strathclyde Business School, Department of Economics.
    11. Christopher J. Neely & Paul A. Weller, 2011. "Technical analysis in the foreign exchange market," Working Papers 2011-001, Federal Reserve Bank of St. Louis.
    12. Osler, Carol & Savaser, Tanseli, 2011. "Extreme returns: The case of currencies," Journal of Banking & Finance, Elsevier, vol. 35(11), pages 2868-2880, November.
    13. Kozhan, Roman & Salmon, Mark, 2012. "The information content of a limit order book: The case of an FX market," Journal of Financial Markets, Elsevier, vol. 15(1), pages 1-28.
    14. Hans Degryse & Frank de Jong & Vincent van Kervel, 2015. "The Impact of Dark Trading and Visible Fragmentation on Market Quality," Review of Finance, European Finance Association, vol. 19(4), pages 1587-1622.
    15. Thierry Foucault & Sophie Moinas & Bruno Biais, 2014. "Equilibrium Fast Traders," 2014 Meeting Papers 1207, Society for Economic Dynamics.
    16. Álvaro Cartea & José Penalva, 2012. "Where is the Value in High Frequency Trading?," Quarterly Journal of Finance (QJF), World Scientific Publishing Co. Pte. Ltd., vol. 2(03), pages 1-46.
    17. Hoffmann, Peter, 2012. "A dynamic limit order market with fast and slow traders," MPRA Paper 39855, University Library of Munich, Germany.
    18. Thornton Matheson, 2011. "Taxing Financial Transactions; Issues and Evidence," IMF Working Papers 11/54, International Monetary Fund.
    19. Hoffmann, Peter, 2012. "A dynamic limit order market with fast and slow traders," MPRA Paper 44621, University Library of Munich, Germany, revised Jan 2013.
    20. Michael R King & Dagfinn Rime, 2011. "The $4 trillion question: what explains FX growth since the 2007 survey?," BIS Quarterly Review, Bank for International Settlements, March.
    21. Keller, Jonas & von der Gracht, Heiko A., 2014. "The influence of information and communication technology (ICT) on future foresight processes — Results from a Delphi survey," Technological Forecasting and Social Change, Elsevier, vol. 85(C), pages 81-92.
    22. Riordan, Ryan & Storkenmaier, Andreas & Wagener, Martin & Sarah Zhang, S., 2013. "Public information arrival: Price discovery and liquidity in electronic limit order markets," Journal of Banking & Finance, Elsevier, vol. 37(4), pages 1148-1159.

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    Foreign exchange rates;

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