FX spot and swap market liquidity and the effects of window dressing∗

This paper assesses liquidity conditions in foreign exchange (FX) spot and derivatives markets using intra-day data against the background of FX dealers’ response to recent regulatory changes. Given that FX swap markets are by some measures even deeper that the spot market, an assessment of FX liquidity requires taking such instruments into account. We find that spot and swap market liquidity is intimately linked. Furthermore, the co-movement between FX funding and market liquidity, as gleaned from the pricing of both types of instruments, has increased over time. This development relates to dealer balance sheet capacity. While top dealers continue to dominate liquidity provision in spot, they tend to pull back from market-making in FX swaps around regulatory reporting periods. This shifts market-making activity in FX derivatives towards smaller, more expensive and less informed, dealers, and also results in adverse spillovers to liquidity conditions in spot markets. JEL classification: F31, G15