Handbook of Exchange Rates

1.3 Players and Information in FX Market

A key goal of exchange rate economics is to understand currency returns. Exchange rates, like asset prices, more generally, move in response to new information about their fundamental value. Over the past decade, microstructure research has revealed that this “price discovery” process involves different categories of market participants. Each participant's distinct role is determined by (i) whether the agent is a liquidity maker or taker and (ii) the extent to which the agent is informed.

The original FX market participants were traders in goods and services. Currencies came into existence because they solved the problem of the coincidence of wants with respect to goods. Most countries have their own currencies, so international trade in goods requires trade in currencies. The motives for currency exchange have expanded over the centuries to include speculation, hedging, and arbitrage, with the list of key players expanding accordingly. Beyond importers and exporters, the major categories of market participants now include asset managers, dealers, central banks, small individual (retail) traders, and, most recently, high frequency traders.

“Dealers” or “market makers” emerged naturally to fulfill the search function among trading counterparties. Dealers stand ready to trade with anyone needing FX at a moment's notice. To initiate an FX trade, an agent calls a dealer indicating the currency and quantity she/he wishes to trade and asking for ...