The dark side of foreign exchange liquidity

Nina Karnaukh, Angelo Ranaldo, Paul Söderlind

10 September 2015



Market liquidity is an important feature for all financial markets (e.g. PWC 2015), yet relatively little is known about the liquidity of the foreign exchange market. A clear understanding of why and how foreign exchange illiquidity materialises is still missing. For instance, we do not know the fundamental sources driving foreign exchange liquidity and comovements in liquidity of individual currencies (the so-called commonality in market liquidity). In a recent paper (Karnaukh et al. 2015), we investigate foreign exchange liquidity and its commonality over more than two decades and 30 exchange rates. We first identify accurate measures of foreign exchange liquidity, and then uncover which factors explain the time-series and cross-sectional variation of foreign exchange liquidity.

An in-depth understanding of foreign exchange liquidity is important for at least three reasons:

  • First, the foreign exchange market is the world's largest financial market with a daily average trading volume of more than five trillion US dollars in 2013;
  • Second, the foreign exchange market is crucial in guaranteeing efficiency and arbitrage conditions in many other markets, including bonds, stocks, and derivatives;
  • Third, the foreign exchange market has unique characteristics, so foreign exchange liquidity patterns may differ from those of other asset markets.

Our paper contributes to the international finance literature in three ways. First, we provide a methodological contribution to the measurement of foreign exchange liquidity using daily and readily available data. Second, to date foreign exchange liquidity has been comprehensively analysed only over short periods (e.g. Mancini et al. 2013) or using specific measures, such as the order flow or the bid-ask spread based on indicative quotes. Thus, it has been difficult to explain the significant temporal and cross-sectional variation in currency liquidity. Third, our study sheds light on the determinants of commonality in foreign exchange liquidity.

Some clear results emerge from our study. First, foreign exchange liquidity can be measured accurately using low-frequency (daily) data that are readily available. To support future research on this area, we made publicly available our data and detailed information to compute foreign exchange liquidity using low-frequency data.1 Second, we show that foreign exchange liquidity is mainly affected by funding constraints and by global risk dynamics. Figure 1 shows the patterns of foreign exchange liquidity around four representative events: (1) the sterling crisis (‘Black Wednesday’) in September 1992; (2) the Asian financial crisis in July 1997; (3) the announcement of the MSCI global equity index redefinition in early December 2000; and (4) the unexpected joint decisions of several central banks to lower the pricing on the US dollar liquidity swap arrangements by 50 bps at the end of November 2011.

Figure 1.

For each event, the effective trading cost is estimated for two groups of currencies: those directly affected by the event, and those not. The first two events are representative examples of deteriorating market conditions, while the third and fourth events might be considered more genuine shocks to the demand and supply of foreign exchange liquidity. This simple event study shows that foreign exchange liquidity is impaired during crisis episodes. It also suggests that foreign exchange liquidity reacts to seemingly exogenous shocks to demand and supply of liquidity, consistent with supply-side hypotheses as postulated by recent theoretical models (e.g. Vayanos and Gromb 2002, Brunnermeier and Pedersen 2009) and the previous literature focusing on specific episodes of demand pressure (e.g. Hau et al. 2010). Our regression analysis extends these results, showing that these effects are even stronger for developed currencies and foreign exchange rates bearing larger exposure to risk factors, such as those representing the investment leg of a classical carry trade strategy.


What are the main implications for policymakers and market participants? We think that our results highlight at least two dark sides of foreign exchange liquidity:

  • First, they suggest a new dimension of risk spillover effects, that is, foreign exchange liquidity can be impaired in times of flight to quality and higher global risk.

The significant temporal and cross-sectional variation in currency liquidities documented in our paper challenges the ‘static’ approach pervasive in the new liquidity requirements, such as Basel III.

  • Second, commonality increases in distressed markets, especially when funding constraints are tighter, global risk increases, and when foreign exchange carry trade strategies incur substantial losses, that is, exactly when foreign exchange speculators ‘rush to exit’ and need liquidity to offload their positions.

Also, commonality in foreign exchange liquidity is stronger for more-developed currencies with better credit ratings. For policymakers, these results point to another dark side of foreign exchange liquidity – some institutional features, typically highly praised ones, such as financial integration and openness, may expose currencies to global liquidity shocks.


Brunnermeier, M K, and L H Pedersen (2009), “Market liquidity and funding liquidity”, Review of Financial Studies 22: 2201–38.

Gromb, D, and D Vayanos (2002), “Equilibrium and welfare in markets with financially constrained arbitrageurs”, Journal of Financial Economics 66: 361–407.

Hau, H, M Massa, and J Peress (2010), “Do demand curves for currencies slope down? Evidence from the MSCI global index change”, Review of Financial Studies 23: 1681–717.

Karnaukh, N, A Ranaldo, and P Söderlind (2015), “Understanding foreign exchange liquidity”, Review of Financial Studies, forthcoming.

Mancini, L, A Ranaldo, and J Wrampelmeyer (2013), “Liquidity in the foreign exchange market: Measurement, commonality, and risk premiums”, Journal of Finance 68: 1805–41.

PWC (2015), “Global financial markets liquidity study”, report, August.


1 The updated time series of foreign exchange liquidities are available at and the data analysed in Karnaukh et al. (2015) are available on the Review of Financial Studies website as supplementary material.



Topics:  Financial markets

Tags:  foreign exchange, illiquidity, liquidity, FX

PhD student in Finance, University of St. Gallen

Professor of Finance and Systemic Risk, University of St.Gallen

Professor of Finance, University of St. Gallen