Hide Information and Seek Liquidity: A Game of Strategic Triangular Trading

ABSTRACT:
In the FX market large liquidity coexists with systemic asymmetric information. This fact is counter-intuitive. I propose a novel strategic triangular trading model where a risk-averse insider can trade currency pairs both directly and indirectly, through a third currency. In each of the three markets, the insider trader takes into account also the market liquidity in the other two markets when choosing the optimal trading strategy. Market liquidity and trading aggressiveness are sensitive to the amount of noise trading and the private information’s features. The numerical sensitivity analysis reveals limited risk-bearing capacity of the insider trader and limited cross-learning capacity of the market maker. The model could decipher the actual behaviour of better informed high-frequency trading firms and hedge funds, who have become major determinants of cross-market FX liquidity. Moreover, a solid theoretical understanding of FX market liquidity could help policy makers to better address financial stability risks affecting entire currency networks.