FX spot and swap market liquidity spillovers

BIS Working Papers  |  No 836  | 
13 January 2020


Liquidity conditions in the foreign exchange (FX) spot market can be affected by liquidity dislocations in FX swaps. There are three reasons for this: first, the pricing of spot and FX swaps is linked; second, FX swaps have increased in importance as FX funding instruments, which has implications for FX liquidity; and third, there is a significant overlap between dealers providing liquidity in both market segments.


Previous studies of FX market liquidity have focused exclusively on the spot market. By contrast, this paper takes into account the enormous importance of FX swaps in global FX trading. In this context, we also analyse the joint behaviour of funding and market liquidity in FX. Our identification strategy relies on exogenous quarter-end funding liquidity shocks in FX swap markets to study their effects on spot market liquidity. We also add to the studies that examine the relationship between FX market liquidity and dealer competition. Finally, we contribute to the academic literature on covered interest parity (CIP) deviations by documenting supply side drivers of the dislocations related to the pull-back of trading desks belonging to global systemically important banks (G-SIBs).


First, bid-ask spreads in spot and FX swaps are highly correlated. Second, deterioration in FX funding liquidity, as measured by forward discount or CIP deviations, is associated with a widening of bid-ask spreads in spot FX. Third, this link between FX funding and market liquidity conditions has strengthened significantly since mid-2014. Fourth, the partial shift of intermediation in FX swaps toward smaller dealers as the desks of G-SIBs periodically pull back is behind much of the liquidity dynamics described.


We study the joint evolution of foreign exchange (FX) spot and swap market liquidity. Trading in FX swaps exceeds that of spot, yet this market segment has been largely ignored in prior research on liquidity in FX markets. We find strong co-movement in spot and swap market liquidity conditions and a strong link between FX funding and market liquidity, as gleaned from the pricing of both instruments. This link has strengthened over time with changes in dealer behaviour. Some of the largest dealers periodically pull back from pricing FX swaps and wider spreads attract smaller dealers. At the same time, liquidity in FX swaps remains impaired, which leads to adverse illiquidity spillovers to the spot market. Our findings suggest that funding liquidity has become a more important driver of spot market liquidity than it used to be.

JEL codes: F31, G15

Keywords:  foreign exchange, market and funding liquidity, microstructure, dealer activity, window dressing