ASYMMETRIC INFORMATION AND THE CROSS-SECTION OF CURRENCY SPREADS

Abstract

This paper shows that the spreads charged by currency dealers vary inversely with deal size and that they are wider for importers and exporters than for asset managers and other dealers. This pattern is the opposite of that predicted by standard models of market making under asymmetric information, given the information structure of currency markets. The paper suggests that private information gives certain customers market power relative to their dealers. Symmetrically, it suggests that dealers strategically quote narrower spreads to privately informed customers to increase their access to information. Finally, the paper suggests that dealers primarily seek information about transitory market developments rather than fundamentals.

Full text

Page 1

ASYMMETRIC INFORMATION AND THE CROSS-SECTION OF
CURRENCY SPREADS

Alexander Mende, University of Hannover, Germany
Lukas Menkhoff, University of Hannover, Germany
Carol L. Osler, Brandeis University, USA *





Abstract
This paper shows that the spreads charged by currency dealers vary inversely with deal size and
that they are wider for importers and exporters than for asset managers and other dealers. This
pattern is the opposite of that predicted by standard models of market making under asymmetric
information, given the information structure of currency markets. The paper suggests that private
information gives certain customers market power relative to their dealers. Symmetrically, it
suggests that dealers strategically quote narrower spreads to privately informed customers to
increase their access to information. Finally, the paper suggests that dealers primarily seek
information about transitory market developments rather than fundamentals.






October 2004







Corresponding author: Lukas Menkhoff, Department of Economics, University of Hannover, D-30167 Hannover,
Germany, menkhoff@gif.uni-hannover.de; Alexander Mende, Department of Economics, University of Hannover,
Königsworther Platz 1, D-30167 Hannover, Germany, mende@gif.uni-hannover.de; Carol Osler, Brandeis Interna-
tional Business School, Brandeis University, 415 South Street, Waltham, MA 02454, USA, cosler@brandeis.edu.
We are grateful for helpful comments from Alain Chaboud, William Clyde, Peter Eggleston, Thomas Gehrig, Val-
erie Kraus, Peter Nielsen, Dagfinn Rime, Erik Sirri, Erik Theissen, and Peter Tordo, along with participants at sev-
eral seminars and the Stockholm Workshop on FOREX Microstructure and International Macroeconomics. We are
deeply indebted to the bankers who provided and discussed the data with us.

Page 2

ASYMMETRIC INFORMATION AND THE CROSS-SECTION OF
CURRENCY SPREADS

1. Introduction
This paper examines the cross-section of currency spreads. From the seminal papers on
dealing under asymmetric information we learn that spreads compensate market makers for their
losses to privately informed counterparties (Copeland and Galai, 1983; Glosten and Milgrom,
1985; Easley and O'Hara, 1987). Thus, spreads should rise with the likelihood that a given
counterparty has private information, other things equal, a likelihood that depends on deal size
and counterparty type. Spreads should vary positively with deal size because, as shown by
Easley and O'Hara (1987), informed traders have an incentive to undertake larger trades. Spreads
should be narrower for counterparty types considered less informed if dealers can discriminate
among them. Since currency dealers generally do know their counterparty's type the narrowest
currency spreads should therefore be enjoyed by importers and exporters ("commercial
customers"), since they are considered less informed than asset managers and hedge funds
(jointly "financial customers") or other dealers.
This paper shows that spreads charged by currency dealers conform to the opposite of
these two predictions: They are inversely related to deal size and are wider for commercial
customers than for financial customers and other market makers. The resulting variation in
spreads is substantial. Average spreads vary from about 2 pips for large interbank deals to about
20 pips for small deals with commercial customers.1 The paper suggests two mutually consistent
explanations for this pattern, both based on asymmetric information. According to the first,

1 A pip is the smallest unit in an exchange-rate quote. For USD/EUR one pip equals USD 0.0001.

Page 3

2
private information gives certain customers market power relative to their dealers. According to
the second, dealers strategically quote narrower spreads to privately informed customers to
increase the chances of transacting with them, thereby gathering some of their information. The
paper also notes that, even though the familiar models cited above do not explain how the
absolute size of currency spreads varies cross-sectionally, they do explain why the share of the
asymmetric information component of spreads is positively related to deal size and is lowest for
commercial customers.
Our data comprise the entire USD/EUR transaction record of a bank in Germany over four
months in 2001. These data have two advantages relative to other currency transaction data
analyzed in the literature: they distinguish between financial and commercial customers, and
they cover a longer time period. The earliest study of currency spreads using transaction data,
Lyons (1995), concludes that spreads on interdealer transactions vary positively with deal size,
as predicted by Copeland and Galai (1983), Glosten and Milgrom (1985), and Easley and O'Hara
(1987) ("the standard models"). More recent studies generally find little relation between
currency spreads and deal size (Yao, 1998; Bjønnes and Rime, 2003).
Though not previously identified in the literature, the negative relationship between
currency spreads and deal size found here is not just widely known, it is deeply woven into the
fabric of thought in the practitioner community. A similar relationship holds in the U.S.
municipal bond market (Green, Hollifield, and Schurhoff, 2004; Harris and Piwowar, 2004). By
contrast, the relationship between spreads and deal size is positive in U.S. equity markets
(Peterson and Sirri, 2003).
The pattern of spreads in stock markets can presumably be explained by the adverse
selection costs highlighted in the standard models. Indeed, real-world stock markets provided the

Page 4

3
inspiration for these models. To explain the pattern of spreads in municipal bond markets, Green,
Hollifield and Schurhoff (2004) highlights that market's dealership structure and the associated
dispersion of information. In opaque markets, agents with knowledge of current market
conditions, like dealers, have market power. Green, Hollifield and Schurhoff (2004)
hypothesizes that agents making small municipal deals are tend to be poorly informed about
market conditions, a tendency that gives dealers the market power to extract wider spreads. This
logic can be apply directly to explain the inverse relationship between spreads and deal size in
currency markets, since small currency transactions also tend to be undertaken by uninformed
agents.
Green, Hollifield and Schurhoff's (2004) analysis can also explain our finding that financial
customers in currency markets pay lower currency spreads than commercial customers, since
financial customers are generally well informed about market conditions while commercial
customers are not. In addition, financial customers have private information about their own
large trades and large stop-loss and take-profit orders (Osler, 2003).2 Since deal flow is a key
determinant of exchange-rate dynamics (Evans and Lyons, 2002), and financial deal flow in
particular appears to be a key factor in extreme high-frequency moves (Fan and Lyons, 2003),
information about large trades and large orders can be critical to market makers.3 This private
information enhances financial customers' market power relative to their dealers and allows them
to demand narrower spreads.

2 Stop-loss and take-profit orders are conditional market orders, where the conditioning variable is market price. A
stop-loss order instructs a dealer to buy (sell) a specific amount at market prices if and only if the market price rises
(falls) to a certain pre-specified level. A take-profit order instructs a dealer to sell (buy) a specific amount at market
prices if and only if the market price rises (falls) to a certain pre-specified level. Orders are distinct from regular
deals, in which a market maker provides a two-way quote and the counterparty chooses whether to deal at those
prices.
3 Deal flow is defined as the net of buy-initiated and sell-initiated deals over a given interval.

Page 5

4
The benefits from learning financial customers' private information provide a strategic
incentive for dealers to quote narrow spreads to such customers. When market makers compete
with each other as in dealerships markets, the more attractive a dealer's quoted spreads the more
likely customers are to transaction with that dealer, both now and in the future, and the more
chances that dealer will have to learn about their trading activity. That is, currency dealers may
not passively accept the information content of deal flow, as assumed in standard models, but
may instead set prices strategically to increase their access to information. This strategic dealing
hypothesis complements, and is fully consistent with, the market power hypothesis.
The possibility of strategic dealing was originally explored in theoretical papers by
Gammill (1989) and Leach and Madhavan (1992, 1993), which show that dealers may rationally
adjust prices in early transactions with the goal of becoming more informed, and thus more
profitable, in later transactions. In the Leach and Madhavan models, specialists rationally quote
wider spreads at the beginning of a trading session, driving informed trades out. In Gammill's
model, dealers choose to take a loss on early trades, driving informed trades in. Our hypothesis is
closest to Gammill's.
The hypothesis that currency dealers strategically subsidize deal flow with informed
customers raises the question: Are currency dealers seeking to gain fundamental information or
information about transient market developments? Consistent with the hypothesis that dealers
seek fundamental information (Evans and Lyons, 2002, 2004), we show that interbank and
financial-customer deal flow are both positively cointegrated with exchange rates. Nonetheless,
we propose that dealers primarily seek information about transient market developments ("non-
fundamental information"), and provide three justifications for this view. First, fundamentals are
primarily relevant in the long run, but currency dealers generally close their positions by the end