DP2510 | The Euro as an International Currency: Explaining Puzzling First Evidence

Publication Date

25/07/2000

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Abstract

This paper presents evidence that the bid-ask spreads in euro rates increased relative to the corresponding bid-ask spreads in the German mark (DM) prior to the currency union. This comes with a decrease in transaction volume in the euro rates relative to the previous DM rates. The starkest example is the DM(euro)/yen rate in which the spread has risen by almost two-thirds while the volume has almost halved. We propose a microstructure theory for a system of multiple exchange rates in which spreads are endogenously determined. It is argued that the elimination of cross rates due to the introduction of the euro reduced the intra-temporal risk sharing capacity of the multicurrency dealership market. A second explanation for the increase in the euro bid-ask spreads and the relative euro volume loss is based on an increase in the information content of order flow in euro rates relative to previous DM rates.