In my post last week I took up the question of why someone would trade forex, looking a recent online debate of the subject. One of the aspects of said debate was the question of forex market efficiency. Perhaps coincidentally, there’s a new post up on the Liberty Street Economics blog (run by the NY Federal Reserve research group) which takes up the question of efficiency in exchange rates. The following graph is meant to be a visual depiction of that efficiency where EUR/USD is concerned:
What the chart shows is basically the frequency with which one could find triangular arbitrage opportunities in the market because of bid/ask quote discrepancies between forex dealers. In the early 2000s this was quite common, but that started to decline in the middle part of the decade and now is almost non-existent. The blog author cites increased automated and algorithmic trading in the market as the driving force. It’s hard to make a counter argument. Just looking at the rapid narrowing of spreads across all the major currency pairs backs up the increased efficiency in the markets these days from that perspective.
By the way, this improved efficiency is also a function of the competitiveness of the forex business overall. The estimates suggest high frequency trading in forex remains only a fraction of what is seen in the US equity markets, so it isn’t as big a force on things here. Lots of people piling into the market trying to earn a buck, however, definitely has had an impact. As the business of forex has grown, so has the battle for profits from it. That competition has helped motivate more efficient systems and narrower bid/ask spreads in the pursuit of customer business at all levels.
One of the other points made in the post is that unlike other markets, forex did not see a major efficiency issue during the Financial Crisis. The market continued to operate fairly smoothly. Certainly it was subject to volatility like everything else, but it wasn’t volatility driven by liquidity issues as seen in other places, like the fixed income markets. Certainly we’ve seen nothing like a Flash Crash.
That said, as I mentioned last week, market efficiency isn’t just about mechanical issues such as what the Liberty Street blog post evaluates. It’s also about how participants interpret and act upon in formation – the over/under-reaction question. Yes, forex might be a highly efficient market on a technical basis, but it is subject to psychological inefficiencies like any other.