Comparative Research On The Trading Mechanism Of Foreign Exchange Market Based On Market Microstructure Theory

Market microstructure theory argues that trading mechanism which will affect the traders'behavior and market liquidity, volatility, effectiveness, transaction costs and other basic elements of microstructure is not an exogenous variable. It has a profound impact on the price formation process and the price behavior. Therefore, the research related to this area reveals the behavior of prices and market characteristics, which in turn means a lot to the authority for it can help them redesign a more efficient trading mechanism and enhance market supervision. Foreign exchange market (FX market), shares common characters as the world's largest financial market, but differs in some way. It is a global double-level decentralized market linked by communications network across time zones. Therefore, when market microstructure theory is used to analyze the FX market, we need to take these specialties into account. The FX market microstructure theory is the combination of general theory of market microstructure and FX market, through which we can have a better idea about the formation process of the exchange rate changes, improving the efficiency and market performance of the FX market.The main idea of this paper is analyzing the trading mechanism and market structure of FX market. It follows the idea from the general theory to the specific research, summarizes the general financial market microstructure theory, identifies the research object of this paper is general trading mechanism, including market access mechanisms, price formation mechanism and the clearing mechanism. Then it analyzes the specialties of the FX market, which are induced by its unique market structure:The exogeneity of the inventory position, the existence of private information, and non-synchronousity of payment. These specialties result in some risks, such as credit risk, market risk, inventory risk, information asymmetry, liquidity risk and systemic risk. These risks will put different effects on different mechanism respectively:market access mechanism is subject to credit risks, the price formation mechanism is subject to market risk, inventory risk and impact of private information, and liquidation mechanism is mainly affected by credit risk, liquidity risk and system risk. The existence of these risks led to different transaction costs which as it turns out provide a basis for comparison among different market structures, so a better arrangement may be put up with through this comparison Through research, some conclusions have been reached:In the market access mechanism, centralized exchange performs better when credit risk want to be solved. Although running a exchange leads to extra costs, it is a trend of future development. In the price formation mechanism,the centralized auction mode shows more market transparency, the profitability of private information is small, while the decentralized market OTC transaction shows low transparency, the profitability of private information is larger, these two transaction models generate the same middle price, which means that despite the different trading mechanisms, the traders evaluation on the foreign exchange is the same. But the spread is higher in OTC transaction because of the search costs. In the clearing mechanism, the gross multi-currency settlement, can effectively reduce the credit risk. The multilateral net settlement can reduce liquidity risk.At last, we use what we've found so far to study the interbank FX market in China, we introduce the development process of China's interbank FX market, the existing trading system. And we divide the research interval by using the event of exchange rate formation in July 2005, compare the market access, pricing mechanism and the clearing mechanism before and after this formation, some suggestions for future development have been listed based on our reseach.