Strategic trading in a two-sided foreign exchange auction

Abstract

The market microstructure chosen for foreign exchange markets can influence trading volumes and equilibrium exchange rates. With emerging markets and developing countries increasingly utilizing two-sided auctions, we show that the choice of the discrete `tâtonnement' auction creates incentives for strategic behavior among market participants. Theoretical predictions on strategic under-revelation of demand or supply positions are supported empirically using detailed data from a rare example of a tâtonnement market, the Moscow Interbank Currency Exchange. Our results suggest that market microstructures should be introduced alongside more traditional asset-market fundamentals in studies of foreign exchange market activity, especially in developing countries.

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