Working Paper: CEPR ID: DP2510
Authors: Harald Hau; William Killeen; Michael Moore
Abstract: This paper presents evidence that the bid-ask spreads in euro rates increased relative to the corresponding bid-ask spreads in the German mark (DM) prior to the currency union. This comes with a decrease in transaction volume in the euro rates relative to the previous DM rates. The starkest example is the DM(euro)/yen rate in which the spread has risen by almost two-thirds while the volume has almost halved. We propose a microstructure theory for a system of multiple exchange rates in which spreads are endogenously determined. It is argued that the elimination of cross rates due to the introduction of the euro reduced the intra-temporal risk sharing capacity of the multicurrency dealership market. A second explanation for the increase in the euro bid-ask spreads and the relative euro volume loss is based on an increase in the information content of order flow in euro rates relative to previous DM rates.
Keywords: microstructure; spreads; transaction costs; vehicle currency
JEL Codes: F33; G15
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| introduction of the euro (F36) | increased bid-ask spreads (G19) |
| introduction of the euro (F36) | decreased trading volumes (G19) |
| increased bid-ask spreads (G19) | decreased trading volumes (G19) |
| elimination of cross rates (F31) | increased bid-ask spreads (G19) |
| increased information content of order flow in euro rates (G15) | increased bid-ask spreads (G19) |