We characterise the liquidity provision and price discovery roles of dealers and high-frequency traders in the foreign exchange spot market.
In the sample period between 2012 and 2015, we find that high-frequency traders (HFTs) and dealers have different responses to adverse market conditions.
HFT liquidity provision is less sensitive to spikes in market-wide volatility, while dealer bank liquidity is more robust ahead of scheduled macroeconomic news announcements when adverse selection risk is high. In one period of extreme level of volatility in our sample, the Swiss franc de-peg, HFTs appear to withdraw almost all liquidity while dealers remain.
In normal times, HFTs contribute to market liquidity by passively trading against the pricing errors created by dealers' aggressive trade flows.
On price discovery, HFTs contribute the dominant share, mostly through their high-frequency quote updates which incorporate public information. In contrast, dealers contribute to price discovery more through trades that impound private information.
Wenqian Huang, Peter O’Neill, Angelo Ranaldo and Shihao Yu.
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