The Market Microstructure Approach to Foreign Exchange: Looking Back and Looking Forward

Research on foreign exchange market microstructure stresses the importance of order flow, heterogeneity among agents, and private information as crucial determinants of short-run exchange rate dynamics. Microstructure researchers have produced empiricallydriven models that fit the data surprisingly well. But FX markets are evolving rapidly in response to new electronic trading technologies. Transparency has risen, trading costs have tumbled, and transaction speed has accelerated as new players have entered the market and existing players have modified their behavior. These changes will have profound effects on exchange rate dynamics. Looking forward, we highlight fundamental yet unanswered questions on the nature of private information, the impact on market liquidity, and the changing process of price discovery. We also outline potential microstructure explanations for longstanding exchange rate puzzles. 2013 Elsevier Ltd. All rights reserved. q The authors would like to thank Michael Melvin, Geir Bjønnes, Alain Chaboud, Martin Evans, Ingrid Lo, Lukas Menkhoff, Michael Sager, Elvira Sojli, Mark Taylor, Paolo Vitale, and participants at the Journal of International Money and Finance 30th Anniversary conference in New York for helpful comments and suggestions. We thank Alain Chaboud and Clara Vega for the order flow regressions using EBS data. The views expressed in this paper are those of the authors and do not necessarily represent those of the Norges Bank. Michael King acknowledges financial support from the Bank of Montreal Fellowship. * Corresponding author. Ivey Business School, UWO, 1151 Richmond Street N, London, Ontario, Canada N6A 3K7. Tel.: þ1 519