Dealer Quotes, Order Flow and Indirect Foreign Currency Utility in a Multiple Dealership Market

The paper proposes a model of multiple dealer forex trade in two variants: for direct and brokered market organization. The equilibrium order flow pattern is derived as a function of shadow prices (marginal valuations) of FX holdings across market participants. The shadow currency values can be heterogeneous across market participants (due to differences in preferences, endowments or asset payoff information), giving rise to nonzero trades in equilibrium. Purchases (sales) of the currency are initiated by those market users whose marginal currency values are high (low) in relation to the marginal valuations of the market maker. As a consequence, one would observe a strong price impact of the order flow when it moves the marginal value of the recipient dealer away from the no-trade level, and a weak order flow impact when the received position reverts the marginal value back to it. The Nash equilibrium of the studied one period inter-dealer game is obtained as a steady state Nash equilibrium of a differential game between the same players. We also find that differences in equilibrium quoting behavior result in higher volumes of inter-dealer trade in the brokered market compared to the direct market. However, under both trading mechanisms hot potato trades are non-zero even if the dealers are perfectly symmetric. For a given level of non-dealer investor foreign currency demand, gains from trade in the brokered market are lower than in the direct market.