Foreign exchange markets suffer excess volatility caused by their current design, which mixes fundamental and speculative transactions. As current market makers enthusiastically embrace new digital trading systems, speculative foreign exchange volume and volatility grow apace with this rapid technological evolution. In turn, the enormous trades and rate movements in excessively volatile foreign exchange markets increasingly undermine central bank efforts to fulfill their primary mission of monetary stability in their economies.
This paper proposes a new foreign exchange market design which separates fundamental and speculative transactions. This new market design uses fundamental transactions to periodically discover that exchange rate which equilibrates the fundamentals. Central banks then offer unlimited liquidity at the fundamental exchange rate to ensure that it holds for all transactions, and particularly for the speculative transactions excluded from the rate setting process.
By excluding speculative transactions from rate-setting, this new market design channels destabilizing speculation into changes in international reserves rather than changes in exchange rates. Uncoupling destabilizing speculation and exchange rates keeps speculators from sparking the herd movements among foreign exchange traders that create self-fulfilling prophecies in exchange rate movements. With this design, total volatility should decline to fundamental levels, foreign exchange rate changes should better reflect changes in the real economy, and speculative volume should fall substantially as speculators seek more rewarding venues.
Empirical differences between closed-end and open-end fund behavior support this market design's logic. Closed-end fund prices bubble and crash as herds of traders bet on and extend price trends, but parallel behavior in open-end fund quantities is unknown. That's because open-end fund managers have an accurate value signal which lets them correctly channel potentially destabilizing speculation into changes in shares outstanding rather than changes in market prices. Lacking such accurate information, central bankers often vainly change international reserves in attempts to stabilize exchange rates at levels inconsistent with economic fundamentals, and thereby weaken their efforts to counteract destabilizing speculation. This new market design uses fundamental exchange rates to directly guide central bankers to reserves policies consistent with the liquidity needs of international commerce and direct investment.
Contact Dr. Mark White at: White & Associates, Ciudad Victoria #21, Col. Olivar de los Padres, 01780 Mexico, D.F., MEXICO; Phone (525)595-6045; Fax (525)683-5874; Email: white@profmexis.sar.net
1.0 Introduction
Foreign exchange markets, like most other markets, suffer from outbreaks of severe excess volatility. Unlike most other markets, though, foreign exchange markets trade an asset class, currencies, which supplies liquidity for virtually all fundamental and speculative transactions in the world economy. Thus, a bubble or crash in a foreign exchange market affects entire national economies, rather than just a firm or class of firms as in a typical stock or bond market bubble or crash. Furthermore, mispricings in foreign exchange markets inevitably and directly misguide the real flows in all crossborder fundamental transactions, while mispricings in secondary stock and bond market only misguide the speculative flows in financial transactions when firms neither launch primary market offerings in response to overpricing nor cancel due to underpricing. Policymakers should well note the difference between markets whose mispricing directly shuts down otherwise-viable businesses and markets that simply sting speculators who bet on the wrong asset.
This difference between foreign exchange markets and most others not only highlights the particular importance of eliminating excess volatility in foreign exchange markets, but also suggests a new market design to eliminate excess volatility. Existing foreign exchange market designs combine such essentially fundamental, primary markets transactions as international commerce and direct investment with such essentially speculative, secondary markets transactions as portfolio investments and cross-border deposits. In principle, then, a new foreign exchange market design could separate fundamental transactions from the speculative to discover an exchange rate that equilibrates just the fundamentals. Tied directly to real flows of goods, services, and investments, the fundamental exchange rate should consistently exhibit the correct fundamental volatility, with neither the excess volatility inherent in speculators' perennial attempts to transform leveraged transactions into self-fulfilling prophecies nor the insufficient volatility inherent in regulators' perennial attempts to fix exchange rates.
Once the new foreign exchange market discovers the fundamental exchange rate that equilibrates fundamental flows, central bankers should offer unlimited liquidity to the open market at that fundamental rate and thereby apply a single, correct rate to all transactions, fundamental or speculative. Any supply/demand imbalance in speculative transactions at the fundamental rate would then automatically increase or decrease the central banks' international reserves, so that a hot money influx into portfolio investments and crossborder deposits would naturally build the reserves needed for its eventual liquidation. By automatically channeling hot money into changing reserves rather than exchange rates, this new foreign exchange market design eliminates the excess volatility that stems from the link between destabilizing speculative transactions and concurrent rate movements. This design sets exchange rates exclusively with fundamental trades whose profitability depends on real flows, unlike the current interbank markets which set rates primarily with destabilizing speculative trades whose profitability requires turning rate expectations into rate movements via self-fulfilling prophecies.
By uncoupling speculative flows and rate movements, this new market design is the first to directly address the cause of excess volatility in foreign exchange markets: destabilizing speculation. This approach is logical, but the proposal is grounded on something far more important in science: observation. Open-end funds do not bubble and crash like closed-end funds because their primary market design channels speculative flows into quantity adjustments in the number of shares outstanding; these quantity adjustments do not trigger traders' speculative impulses the same way as price adjustments. By parallel design, channeling speculative foreign exchange flows into international reserve quantity adjustments should avoid exchange rate effects stemming from speculators' herd behavior.
Readers should take special care to distinguish this new design from such familiar designs as dual exchange rate markets. Innovative and original, this proposal would take advantage of new technologies from micro-economic and digital engineering to create a completely new market designed expressly to discover the fundamental exchange rate. It would offer market users an integral solution to excess volatility, rather than the usual set of jury-rigged patches that have failed to consistently moderate existing markets whose rules originally evolved to maximize trading volume and cointegrated volatility. This new alternative lets market users keep the best aspects of market signalling while avoiding the bad signals that frequently arise from destabilizing speculation. This design periodically sets a foreign exchange rate with the real flows from fundamental transactions, exactly as it should. Market users and central bankers will favor this new foreign exchange market design's emphasis on accurate exchange rate discovery; existing market makers, accustomed to enormous and rapidly growing volume, will oppose its deemphasis of trading volume and revenues. With the new design, foreign exchange departments would face cuts in profits and headcounts despite overall increase in commercial bank profits thanks to the growing trade and investment propitiated by better price discovery. Strenuous opposition by their market making departments would likely keep commercial banks from voluntarily adopting the new design. Consequently, the implementation of this design will likely depend on those central bankers who seek to stabilize exchange rate volatility at levels that the fundamentals dictate.
Fortunately for the central bankers who would implement this design, infrastructure costs for a new centralized foreign exchange market have fallen right along with the costs for all other new electronic markets. Integrating existing market software and cash transfer standards, central banks could implement and maintain the proposed electronic call double auction for far less than the cost of maintaining a research effort to analytically determine the relevant fundamental exchange rates with the same frequency and regularity as the auctions, and with far greater confidence in the results. In return, central bankers could offer free market making for market users with fundamental trades, compensating these market users for sharing information on their fundamental cash flows.
1.1 Nomenclature
Given the originality of this new foreign exchange market design, this paper will use the term "White market" for a market that separates fundamental and speculative flows to improve price discovery. More generally, it will use the term "white markets" to designate markets that regulators custom-design and promote to harness market forces in pursuit of their regulatory goals (these are conceptual opposites to the "black markets" that evolve independently when regulators attempt to suppress market forces that they perceive in conflict with their pursuit of regulatory goals). Custom-designed markets in general are "Smith markets," in honor of Vernon L. Smith's leadership in the market design movement. Market designers are, of course, marketsmiths.
1.2 Working Paper Outline
This paper proposes a new foreign exchange market design. The design directly addresses the problem of excess volatility in foreign exchange markets; the working paper does so in the second section. The third section outlines the market design, explaining the design rationale and appropriate applications. The fourth section draws conclusions and suggestions for further research.
2.0 Excess Volatility
Existing foreign exchange markets exhibit excess volatility because their designs facilitate speculative transactions (i.e. those based on rate change expectations rather than liquidity needs). Foreign exchange markets work this way for a good reason. Like other markets, they evolved as private institutions guided by owners who seek and perpetuate those rules which maximize the value of their operations. Maximizing revenue from transactions volume is part of this objective, so market owners seek speculative volume as well as fundamental; market makers rapidly drop futures contracts that lack speculative volume. Furthermore, since volume cointegrates with volatility, speculative volume helps increase total volume by increasing total volatility through excess volatility. Hence, brokers and dealers profit from market rules that encourage the destabilizing speculation that causes excess volatility.
Over time, users and regulators have often decried the growing speculation and excess volatility endemic to foreign exchange markets. In response, foreign exchange market makers, along with their intellectual handmaidens, have opposed and will continue to oppose proposals to change those current market designs that maximize the value of their operations. Their primary defense is the efficient markets argument, which asserts that speculation effectively ensures that market prices always equal fundamental values. A secondary defense argues that volume and liquidity cointegrate, so that higher volume stabilizes prices via greater liquidity. A third line of defense argues that economic liberty includes the freedom to organize markets. The first two lines are invalid, the third valid but irrelevant. This section will look at each defense in turn.
2.1 Inefficient Markets
For broker/dealers in pursuit of profit, the imperialist incursion of neoclassical economists into academic financial research was a very fortunate coincidence. They could not have asked for a better intellectual shield than the efficient markets argument, which states that markets only reflect the fundamentals. Against a veritable tide of anomolies, orthodox neoclassicals have tried to defend that position with two basic strategies. Flood and Hodrick [1990]2 typify the more respectable orthodox response to econometric demonstrations of excess volatility by arguing that "Bubble tests require a well-specified model of equilibrium expected returns that has yet to be developed, and this makes inferences about bubbles quite tenuous." Garber [1990]3 typifies economists who simply ignore scientific convention. After stating that "the business of economists is to find clever fundamental market explanations for events," he invents complex scenarios involving a sequence of unobservable expectations to explain away the excess volatility apparent when comparing observed prices with observed fundamentals. Sir William of Occam would not find this second strategy particularly convincing.
Fortunately for the advance of financial science, the excess volatility apparent when comparing observed prices to observed net asset values in closed-end funds resolves the neoclassicals' objections about inadequate equilibrium return models and possibly great expectations. Closed-end funds don't require an equilibrium return model since markets permit direct observation of the net asset values that give fundamental value to their shares, and expectations of fund share payoffs and underlying portfolios payoffs simply cannot differ substantially if markets really are efficient. Thus, the existence of closed-end fund bubbles and crashes provides overwhelming evidence that existing market rules do discover prices with excess volatility.
DeLong and Shleifer [1991] 4, [1992]5 describe closed-end fund bubbles and crashes in 1929-1930 stock markets, and the descriptions of like events in closed-end country funds in 1989-1990 stock markets by Bodurtha, et.al. [1995]6 and Ahmed, et.al. [1996]7 show that trading behavior in markets has not changed significantly in the intervening years. Since Frankel and Froot's [1990]8 description of destabilizing speculation in the foreign exchange markets is perfectly consistent with the process generating undisputed bubbles and crashes in the 1929-1930 and 1989-1990 stock markets, and since econometric tests find excess volatility whether applied to undisputed bubbles and crashes in stock markets or to apparent bubbles and crashes in foreign exchange markets, one can reasonably conclude that existing foreign exchange market designs do not prevent excess volatility. Foreign exchange markets reflect the destabilizing speculation that creates irrational exchange rates as well as the stabilizing speculation that brings rates back to the fundamentals. They are not efficient.
2.2 Destabilizing Volume
Although the evidence shows that market makers' existing designs do not prevent excess volatility, they could still argue that their current designs do ameliorate it: i.e., that speculative volume dampens what would otherwise be yet greater excess volatility in its absence. This argument essentially treats volume and liquidity as equivalents, and offers the conventional wisdom that since greater liquidity dampens volatility, these designs serve the same purpose by encouraging speculative volume. If one accepts this logic, then current designs avoid the heightened excess volatility that would occur when markets were closed and liquidity absent. One must put this appealing logic aside, though, since no matter how much it would ease the measurement burdens financial economists must bear if volume were equivalent to liquidity, it is not. A market with little or no trading may absorb a large order with no price impact; a market with high trading volume may jump in response to every arriving order. What matters, then, is the empirical relationship between volume and volatility.
Again, the evidence that volume and volatility cointegrate is legion. Aside from the overwhelming evidence of extraordinarily high volumes during the 1929-1930 and 1989-1990 closed-end fund bubbles and crashes, the most telling evidence tying excess volatility to trading volume is French and Roll's [1986]9 study of the New York and American Stock Exchanges' Wednesday market closings in the second half of 1968. French and Roll found that Tuesday closes to Thursday openings were significantly less volatile without Wednesday trading than with it, as were Friday closes to Monday openings compared to any pair of weekdays. It seems that current market designs not only permit occasionally severe excess volatility, but that trading under these rules significantly raises volatility relative to simply shutting down the markets. The direct relationship between volatility, volume, and market making revenues makes this result unsurprising, and suggests that market designers might well discover better rules if they place a higher priority on accurate price discovery than on maximizing volume.
2.3 Towards a New Market Design
Although existing market designs are indeed subject to excess volatility, and current designs do indeed aggravate rather than ameliorate the problem, market makers still might ask: "So, what of it?" Foreign exchange markets evolved under rules permitting people to contract freely, and regulators cannot prohibit such contracts without severely inhibiting the international economic freedoms enshrined by such agreements as the OECD and the EU. Of course, this section exaggerates that argument to indicate how market makers wished governments regulated markets, rather than how they actually do. Nonetheless, reforms can honor the cry of "Free men, free markets!" so long as regulators implement new market designs that win the competition for foreign exchange liquidity, rather than simply mandate the closing of existing markets. Such a white market design is the next section's theme.
3.0 Design Outline
Market rules that evolved under the guidance of private foreign exchange market makers trying to maximize volume can be quite counterproductive for central bankers trying to eliminate excess volatility. Central bankers want foreign exchange markets with rules that promote properly priced real transactions and thereby give appropriate guidance to production and consumption, savings and investment. As Vernon L. Smith has noted, marketsmiths can design new markets that use rule sets distinct from those that evolved in the field to produce distinct results. The right rules will help create a foreign exchange market that sends correct signals to maximize the value of economic output while promoting the price stability that is at the heart of the central banker's brief. So, post-Bretton Woods, central bankers need to work with marketsmiths to design a new foreign exchange market that will produce the desired results: market signals without the excess volatility. This section presents a proposal to do just that.
This proposed new foreign exchange market would periodically discover the exchange rate which balances international commerce and direct investment between two nations. Under the direction of both central banks in a bilateral relationship, this new market would use the interbank payments system to give payments for international commerce and direct investment sole access to an electronic call double auction. That auction would then use those fundamental flows to discover the competitive exchange rate for their international payments, creating a White market. The central banks would then provide unlimited liquidity to the open interbank market at that exchange rate. That unlimited liquidity would ensure generally that no other international transactions would set any other exchange rate, and specifically that no speculative transactions have any direct influence on the auction that sets the exchange rate. With fundamental transactions in the direct rate-setting role and speculative transactions relegated to an indirect rate-setting role (via their influence on international reserves and hence the possibility of central bank intervention in the White market), the resulting exchange rate would properly reflect the balance of fundamental activities between the two nations at the time of the auction. The new market would adjust this fundamental exchange rate at frequent regular intervals to avoid any cash flow imbalances in international commerce and direct investment between the two nations.
With the central banks supplying interbank market liquidity at the fundamental exchange rate discovered in the White market, that fundamental rate would hold for all transactions, fundamental or speculative, commercial or financial. This concept of using a distinct subset of transactions to discover a fundamental rate that the central bank would then establish for all other transactions is completely new and original, hence the White market designation. At first hearing, though, economists often mistake this proposal for the old familiar dual-price mechanism with a controlled rate and a free rate. This is an understandable mistake, since this innovative design lacks familiarity and thus demands considerably more effort to perceive than old familiar designs, but it is still a regrettable mistake. The White market has a single freely floating rate established in a competitive foreign exchange auction by the supply and demand of international commerce and direct investment. Since destabilizing speculation typically outweighs stabilizing speculation in the existing process setting exchange rates, this new market design's isolation of speculative transactions from the rate-setting process is highly desirable.
3.1 Speculation, Volatility, and Quantity Adjustments
Comparative studies of trader behavior in markets for open-end and closed-end funds suggest that channeling speculative transactions into reserve quantity adjustement rather than exchange rate adjustments would let the new market discover an exchange rate with substantially lower volatility than existing levels. Among the various forms of speculative transactions, technical speculation based on adaptive expectations of trends produces the dominant share of volume, and these are precisely the transactions that induce excess volatility in floating-rate markets. The new market design would virtually eliminate the effects of adaptive expectations of trends, since only transactions liquidating international accounts payable for real goods and services could access the new market. Organizations with accounts payable might accelerate or decelerate their payments based on their perceptions of trending prices, but their ability to do so is restricted by their own commercial needs. These restrictions mean that the new market design would avoid the extended trends and reversals that induce the excess volatility afflicting the current floating-rate market.
With these natural restrictions on speculation in the new market, most perceptions of trending rates would induce only quantity effects in the open interbank market. In turn, the lower volatility from the new market design would itself limit quantity imbalances in the open interbank market, since behavioral studies and volume/volatility cointegration both suggest that opportunistic speculators prefer markets with high volatility and pronounced trends. In fact, foreign exchange markets based on this design would simply bore such speculators. Thus, the ostensibly unlimited liquidity commitments offered by central banks enforcing the fundamental exchange rate in the open interbank market should remain relatively small in practice. Reinforcing this expectation is the additional fact that the liquidity commitments would only last a short time before the next periodic auction begins resetting the fundamental exchange rate.
The fundamental exchange rate discovered by the new market would have the correct volatility for balancing binational cash flows at relatively stable levels while signalling appropriate economic opportunities. It would avoid both the extreme cash flow imbalances and drastic international reserve changes periodically caused by the insufficient volatility of fixed exchange rates and the inappropriate exchange rate signals periodically stemming from excess volatility in the fundamental and speculative transactions mix inherent in the current interbank foreign exchange market designs.
3.2 Implementation
The new foreign exchange market would use the interbank payments system to channel payments for international commerce and direct investment as limit orders and market orders for execution in an electronic call double auction that would periodically discover this fundamental exchange rate. In an electronic call double auction market, the call periodically establishes a single competitive price with no bid-ask spread. By concentrating liquidity at one point in time, the electronic call double auction enhances liquidity and avoids the bid/ask bounce volatility of a continuous market. This market design would allow individual buyers and sellers to monitor the evolution of the bids and asks in real time over such media as the Internet's World Wide Web. As an incentive to fully inform the market by revealing bids and asks well before the instant central bankers call the market, the call should occur at a random moment within a window lasting a minute or two beyond the deadline for guaranteed access (otherwise, traders would tend to surprise the market with bids and asks sent at the instant before a fixed call).
Eliminating the spread eliminates the major revenue source for market makers, but since central banks would operate this market to discover fundamental exchange rates rather than earn profits, this is actually a desirable feature that attracts order flow from international commerce and direct investment. Also, call auctions give limit orders (those specifying both price and quantity) a greater price-setting role and lesser liquidity-supplying role than do continuous auctions, while giving market orders (specifying quantity only) a greater liquidity-supplying role. This makes the call market more suitable for broad participation by a mix of large and small importers, exporters, and investors, many of who will submit market orders for simplicity's sake. International commerce and direct investment would obtain their required liquidity directly from this call double auction, while portfolio investment would obtain its desired liquidity, after commissions, from existing interbank market makers. Central banks should pay the capital, operating, and maintenance expenses for the White market to create the cost differential between the commission-free access to the new market and the commissions charged by the interbank market that gives international commerce and direct investment an incentive to transact in the new market.
The central banks should find the new market quite affordable thanks to recent and ongoing advances in computational technology, and a real bargain for the unique information set that the new price discovery process would generate. The costs would include monitoring to ensure that bids and offers truly stem from international accounts payable, but these would not be excessive. Automated surveillance, backed by a range of administrative penalties for violators, should suffice for this purpose since motives for fraud are minimal: commissions in the interbank foreign exchange markets tend to be very low and attempts at market manipulation would be need to be quite obvious if would-be manipulators trade on the scale necessary to move the market. The central banks' ability to intervene in the auction with a surprise bid or ask at the exact instant of the call should discourage would-be manipulators from even making the attempt (of course, central banks should take the decision to intervene jointly; an appropriate binational governing body would include representatives from both central banks and treasuries).
The central banks would fix the interbank exchange rate at the periodically discovered fundamental exchange rate by offering liquidity to absorb any imbalances in portfolio investment payments at that rate, increasing or decreasing international reserves as needed. While reserving the right to intervene in the face of persistent financial imbalances, each central bank would endeavor to allow a clean float in the fundamental exchange rate. Market psychology should permit this strategy to work quite well over the long term. The low volatility in the new market will not attract technical speculators, nor will it attract fundamental speculators seeking significant imbalances among cash flows for international commerce and direct investment. Thus, the main liquidity demanders who normally increase or decrease central bank reserves should not demand much liquidity under the new mechanism.
Significant news may provoke a shift in the fundamentals that would create a large imbalance at the exchange rate fixed at the prior auction. In the wake of significant news, the central banks should suspend interbank liquidity for a few minutes while calling a new auction to immediately discover the new fundamental exchange rate. Given truly extraordinary circumstances, the liquidity suspension might last longer and the new call market might open access to all bids and asks, allowing portfolio investment to participate in exchange rate setting along with international commerce and direct investment. Although volatility will be high in such moments, the one-time nature of the opening avoids the persistent trends that propitiate destabilizing speculation. Importantly, such escape valves would ensure that central bank could avoid large increases or decreases in international reserves due to extraordinary circumstances (again, the decision to call special auctions should be taken jointly by the binational governing body).
3.3 Liquidity Considerations
Large importers, exporters, and direct investors are relatively few, and some observers have expressed a concern that the new market could be somewhat lumpy in the absence of speculative demand and supply. Even in markets with relatively few competitors, though, laboratory market and field market observations by experimental economists show that competition usually finds the fundamental price quite rapidly. This should be the case in the new foreign exchange market. Furthermore, the market users themselves can smooth the market to a certain extent, thanks to the liquidity-enhancing call auction design, the widely available real-time monitoring of bids, asks, and market orders (plus real-time communications to permit sunshine trading for large blocks), the timing flexibility (albeit limited) of commercial users, and the greater timing flexibility of direct investors. In any case, the information benefits of setting exchange rates with a process that excludes speculation should outweigh any costs of reduced liquidity.
Furthermore, central banks can apply new foreign exchange market design to all foreign exchange markets regardless of underlying liquidity simply by varying call frequency. For very large binational markets, the calls might occur many times daily; central bankers could auction the principal currencies frequently and simultaneously. For very small binational markets, the calls might occur as infrequently as once a week, and with only one other currency (the largest trading partner's); market users would pay no spreads or commissions even if they traded through a sequence of markets to get from the starting currency to the ending currency. Over the long-term, central bankers could adjust auction frequency, and even the auctioned currency, as needed to concentrate sufficient transactions to achieve a competitive market. Since microeconomic engineers' laboratory results demonstrate that a small number of traders still generate competitive results, and since central bankers will monitor the auctions for any attempts at rate manipulation, these auctions do not require the high trading volumes that the current designs seek.
3.4 Design Applications
This White market design took its inspiration from the peso/dollar market, which has suffered from regular attempts to fix the exchange rate, including a dual-exchange rate scheme that fixed the commercial rate and floated the financial rate, interspersed with free floats and dirty floats characterized by frequent excess volatility. As the most recent fixed-rate breakdown in December 1994 affirms, speculators eventually doom to failure any unilateral attempt to fix the peso/dollar exchange rate. That's because central bankers always offer an asymmetric bet to foreign exhange speculators whenever they attempt to unilaterally fix an exchange rate. Speculators betting against a fixed rate can leverage their resources almost recklessly, secure in the knowledge that at most they will pay transactions costs, since the rate will not move against them if they bet wrong. Conversely, a successful attack can generate enormous profits on their leveraged positions. The Bank of Mexico, and central bankers generally, need an alternative to this untenable position when they seek to eliminate excess volatility in foreign exchange. This White market is designed to offer a credible one.
Given central bankers' generally negative experience with the asymmetric bets involved in fixed rates, and the many speculative opportunities offered in a transition to fixed rates, this new foreign exchange market design might constitute a better alternative than the planned Euro currency. This White market would avoid the excess volatility that has made floating foreign exchange rates much less comfortable than their advocates predicted prior to the Bretton Woods breakdown. The new design would also avoid the need for monetary straightjackets, inconsistent with unique national conditions, to maintain the insufficient volatility of a fixed rate across a multinational currency. National currencies evolved over time as central banks gradually replaced commercial banks issuing their own paper. An attempt to replace national central banks with a supranational central bank leads the European Union into new, uncharted, and potentially dangerous territory. By reducing or eliminating excess volatility in exchange rates, this White market could make that trip unnecessary.
Although this White market has a very important application in reducing or eliminating excess foreign exchange volatility, it is by no means a panacea. Its correct application depends on a relatively clear demarcation between fundamental/primary and speculative/ secondary trading, and a regulatory reserve that can ensure a single price in the fundamental and speculative markets. Agricultural and other physical commodity markets offer the fundamental/speculative demarcation, and governments might make the financial commitment for a regulatory reserve as part of an agricultural stabilization policy. Beyond agriculture, other White market applications seem unlikely. Attacking excess volatility in such purely secondary markets as those in stocks and bonds will challenge marketsmiths to discover new Smith market designs. Schwartz [1988]10 suggests reducing volatility by encouraging corporations to supplement the existing secondary markets with a limited primary call market that implements a preannounced intervention formula when price changes exceed a trigger amount. However, unlike open-end funds, operating corporations with shares trading in excessively volatile secondary markets lack continuously updated information on an appropriate price for primary market interventions, putting them in a position of ignorance similar to central bankers who lack a White market. Central bankers have this proposed remedy for their lack of fundamental information; unfortunately, operating corporation managements do not.
4.0 Conclusions
This White market design is entirely original, and uses market design principles to respond to the threats and opportunities embedded in recent and prospective advances in digital technologies. These advances facilitate the speculative transactions that threaten foreign exchange market stability with great and continuing increases in cointegrated volume and volatility. Without a change in market design, current trends in foreign exchange volume and volatility suggest that growing excess volatility will constitute an ever-greater threat to international commerce and direct investment. At the same time, though, these same technological advances also facilitate the fundamental transactions that could constitute the basis for a new market design limiting the scope of speculation in the price setting process. The new design proposed here would permit market makers to separate out fundamental transactions to discover, in real-time and at very low cost, the fundamental exchange rate.
If central bankers want to eliminate excess volatility from exchange rates, they cannot just patch up existing market designs that evolved to promote speculative volume and its cointegrated excess volatility. As Shirreff [1993]11 notes, none of the traditional patches (capital controls, transaction taxes, non-interest-bearing deposits, capital charges) have worked for very long, since traders and market makers by nature seek ways around them. Keynes probably anticipated this growing problem during the Bretton Woods conference when he argued that central bankers should act as sole market makers for foreign exchange. Keynes thought in terms of fixed exchange rates, however, not having experienced the tremendous economies that electronic computing offers for the periodic discovery of equilibrium exchange rates in competitive call markets. Given present and prospective economies in market making, though, central bankers should start from the ground floor, designing a market to clearly separate speculative influences from the process that discovers exchange rates. This White market design does so.
When market rules misprice assets in secondary markets, they send bad signals but do not necessarily lead to immediate mistakes in bricks, mortar, and equipment. Consequently, foreign exchange markets should ensure that fundamental/primary transactions balance, even if the resulting fundamental exchange rate creates speculative/secondary transactions imbalances that central bank reserves must absorb. To do this, central bankers need exchange rate information that their researchers and analysts simply cannot provide with the desired accuracy. This White market design provides the necessary information via a fundamental auction, and thereby ensures that the central bankers' reserve transactions contribute to stability, appropriate investments, and greater economic growth.
Logic suggests that this White market should eliminate excess volatility. Better than logic, this notion derives its strongest support from the field observation that open-end funds do not suddenly explode in size or liquidate as they might if bubble and crash behavior affected quantity adjustments as strongly as price adjustments. Tying market price tightly to fundamental value and using quantity adjustments to respond to speculative supply and demand successfully stabilizes primary securities markets. Such field observations can teach scientists a great deal prior to controlled laboratory tests, and these observations strongly suggest that a parallel design ought to stabilize foreign exchange markets. Even with firm empirical support from uncontrolled field observations, though, a new design should undergo controlled laboratory tests before any field trials. Consequently, this author ventures the following recommendation: central bankers should fund laboratory tests for this market design, and if those tests uphold the hypothesis that the design reduces or eliminates excess volatility, field trials should follow as soon as the first central banks can hammer out the agreements.
1 Without attributing any responsibility for this paper's contents, the author thanks Sergio Ghigliazza, Francisco Gil, Jesus Marcos, Alonso Garcia, Gustavo Matus, Ernesto O'Farrill, Jose Luis Perez, Raul Feliz, John Scott and seminar participants at EGA-CCM-ITESM, USMCOC, CIDE, and CEMLA for their valuable comments. The author also gratefully acknowledges the support of EGA-CCM-ITESM during this research project. Contact Dr. Mark White at White & Associates, Ciudad Victoria #21, Col. Olivar de los Padres, 01780 Mexico, D.F., MEXICO; Phone (525)595-6045; Fax (525)683-5874. Email: white@profmexis.sar.net
2 Flood, Robert P., and Robert J. Hodrick, "On Testing for Speculative Bubbles," Journal of Economic Perspectives, Vol. 4, No. 2 (Spring 1990), pp. 85-101.
3 Garber, Peter M., "Famous First Bubbles," Journal of Economic Perspectives, Vol. 4, No. 2 (Spring 1990), pp. 35-54.
4 DeLong, Bradford J. and Andre Shleifer, 1991, "The Stock Market Bubble of 1929: Evidence from Closed-end Mutual Funds," Journal of Economic History, Vol. 51, No. 3 (September 1991), pp. 675-700.
5 DeLong, Bradford J. and Andrei Shleifer, 1992, "Closed-End Fund Discounts," Journal of Portfolio Management, Vol. 18, No. 2 (Winter 1992), pp. 46-53.
6 Bodurtha, James N., Dong-Soon Kim, and Charles M.C. Lee, "Closed-end Country Funds and U.S. Market Sentiment," Review of Financial Studies, Vol. 8, No. 3 (Fall 1995), pp. 879-918.
7 Ahmed, Ehsan, Roger Koppl, J. Rosser Barkley, Jr., and Mark V. White, "Complex Bubble Persistence in Closed-End Country Funds," Journal of Economic Behavior and Organization, forthcoming.
8 Frankel, Jeffrey A., and Kenneth A. Froot, "Chartists, Fundamentalists, and Trading in the Foreign Exchange Market," American Economic Review, Vol. 80, No. 2 (May 1990), pp. 181-185.
9 French, Kenneth R. and Richard Roll, "Stock Return Variances: The Arrival of Information and the Reaction of Traders," Journal of Financial Economics, Vol. 17, No. 1 (September 1986), pp. 5-26.
10 Schwartz, Robert A., "A Proposal to Stabilize Stock Prices," Journal of Portfolio Management, Vol. 15, No. 1, (Fall 1988), pp. 4-11.
11 Shirreff, David, "Can Anyone Tame the Currency Market?," Euromoney, No. 259 (September 1993), pp. 60-69.
Get your own Free Home Page