Market microstructure refers to the mechanics of price formation and liquidity provision, whereas market functioning is about the effectiveness and reliability of those mechanics.6 A well-functioning market is one where trades can be executed quickly and with minimal costs and where prices adjust to market-clearing levels in an orderly way. In most cases, a well functioning market requires some combination of market making or a system of order queuing arising from the market microstructure. In other words, the functioning of the market is determined by its microstructure.
The microstructure and functioning of money and foreign exchange markets differ from that of other financial markets because of the singular role of the central bank.7 The central bank is usually the regulator of those markets and is responsible for the development of market institutions. The central bank frequently serves as market maker and dominant supplier of liquidity, particularly in less-developed markets. In a context of shallow markets, the central bank faces the challenge of establishing operating procedures to guide its interventions that balance the need to achieve its policy objectives with the need to promote market development.
Markets may be organized as dealer markets, where market makers provide liquidity by holding inventory and where they aid in price discovery by quoting prices ahead of transactions. In deep markets in which the central bank does not intervene, dealers will adjust their price quotes in response to changes in order flow. In this way, prices will move in response to market fundamentals. However, when markets are shallow or the central bank seeks to control the interest rate or the exchange rate, the central bank often acts as a market maker by providing price quotes and liquidity to the market. Central banks may seek to encourage the deepening of markets by designating authorized or primary dealers to act as market makers. It is important that those dealers have sufficient capital to absorb losses arising from market making and have access to liquidity (including through repo or swap operations with the central bank) to fund their positions.
Central banks also conduct auctions of short-term instruments, repo contracts, and central bank credit; such auctions centralize market activity and concentrate order flows over a short period of time. The central bank may choose to refrain from participating in the auction directly and may allow prices to adjust to clear the market. However, the central bank could actively manage price outcomes by participating in the auction or by imposing cut-off prices.
The functioning of the markets should be assessed by examining the following:
• Market Liquidity. Indicators of liquidity include what the bid-ask spread is, whether large trades can be executed without significant price movements and how quickly they can be executed, and whether order imbalances lead to lasting price movements. Liquidity may differ among market participants, especially if there are exchange restrictions. Further, the withdrawal of dealers from the market during times of crisis can lead to sudden stops in liquidity provision.
• Immediacy of Trades. This immediacy is crucial in money markets because it underpins effective liquidity management and the operation of the payments system.
The presence of dealers or the access to central bank liquidity facilities is important in ensuring that transactions in the money market can be quickly executed.
• Efficiency. Transaction costs in those markets affect the efficiency of financial intermediation and international payments.
• Transparency. The regular and reliable supply of information on market activities facilitates orderly price adjustment and better risk management, and the information can be used to inhibit anticompetitive behavior by market participants.
• Market Participants and Their Behavior. The entry of different participants (hedge funds, pension funds, and insurance companies) and the consolidation of existing participants that has occurred as markets have been liberalized and developed has implications for market functioning. Risk management and trading strategies have also evolved and have led to shifts to market liquidity over time.8
• Transmission of Policy. The effectiveness of market makers, be they the central bank or primary dealers, is a key component for the implementation of monetary policy using indirect instruments and for effective intervention in the foreign exchange market.
• Electronic Trading. The introduction of electronic trading has sharply reduced transaction costs and has led to a mingling of the inter-dealer marker and the dealer-customer market.
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