The choice of direct dealing or electronic brokerage in foreign exchange trading

Abstract

Central bank surveys indicate that the use of electronic brokerage systems account for the great majority of inter-dealer spot foreign exchange market trade execution. This share has grown from zero in the early 1990s and is up sharply from that reported in the surveys taken in 1998. While the surveys point out the rapid growth of electronic brokers as an important FX institution, there has been no research on the microstructure issues that lead traders to choose electronic brokerage (EB) over the historically dominant, and still quite relevant, institution of direct dealing where bilateral conversations (either telephone or electronic) occur between two FX traders and a deal is struck. We provide analysis to further our understanding of the choice of trading venue in foreign exchange.Theory suggests that the choice of trading venue will differ for “large” and “small” traders. This is due to the importance of asymmetric information, transaction costs, and speed of execution. The most likely outcome has direct dealing used for large trades while the EB is used for small trades.The empirical analysis utilizes data on orders submitted to the Reuters EB system. We focus on the duration of time between order submission and finding a match for trade execution. An autoregressive conditional duration (ACD) model is specified using the Burr distribution. Given the price competitiveness of an order, duration is increasing in order size. Because of this longer duration for large orders on the EB, large traders will prefer the direct dealing market to the brokerage. We also find that the greater the depth of the market, the shorter the duration of orders of all sizes. This result is consistent with traders clustering in time to submit orders so as to increase the probability of finding a match.