Academic Research

Technology and the Geography of the Foreign Exchange Market (2023)

Journal of International Money and Finance, 131-2023 with Barry Eichengreen (Berkeley), Arnaud Mehl (ECB) and M. Minesso (ECB)

March 2016 NBER digest, Vox Column and press coverage: Les Echos.

We analyze the impact of technology on the production and trade in services, focusing on the location of foreign exchange transactions and the effect of submarine fiber-optic cable connections. Cable connections between local markets and major financial centers reduce the costs of trading currencies locally and increase the share of currency transactions taking place in the issuing country. But they also attenuate the effect of existing spatial frictions that prevent transactions from moving offshore to take advantage of agglomeration economies and thick-market advantages of major financial centers. In practice, this second effect dominates. Our estimates suggest that the advent of cable connections boosted the share in global turnover of London, the world’s largest trading venue, by as much as one-third.

Macrofinancial Feedback, Bank Stress Testing and Capital Surcharges (2023)

With Tobias Adrian (IMF) and Jose Berrospide (Federal Reserve Board). Draft available soon.

We develop a framework to assess macrofinancial vulnerabilities across the business and financial cycles, and to calibrate a countercyclical capital buffer (CCyB) to account for those vulnerabilities in the context of bank stress tests. A parsimonious model captures the dynamic relationship between bank capital, financial conditions, and GDP growth, quantifies the causal impact of shocks to bank capital on the future distribution of financial conditions and future downside risks to GDP growth, and estimates macrofinancial feedback effects. Our model calibrates a bank capital surcharge, the additional bank capital that accounts for the macrofinancial feedback—typically overlooked in bank stress tests—as a macroprudential tool to avert banks’ amplification of shocks to the economy. Using a Growth-at-Risk based metric as a measure of financial stability risks, we calibrate the size and the timing of the CCyB, as the capital needed to offset the macrofinancial feedback across the business cycle.

Foreign Exchange Interventions Rules for Central Banks: A Risk-Based Framework (2021)

IMF Working Paper No. 21/32 with Romain Veyrune (IMF).

This paper presents a rule for foreign exchange interventions (FXI), designed to preserve financial stability in floating exchange rate arrangements. The FXI rule addresses a market failure: the absence of hedging solution for tail exchange rate risk in the market (i.e. high volatility). Market impairment or overshoot of exchange rate between two equilibria could generate high volatility and threaten financial stability due to unhedged exposure to exchange rate risk in the economy. The rule uses the concept of Value at Risk (VaR) to define FXI triggers. While it provides to the market a hedge against tail risk, the rule allows the exchange rate to smoothly adjust to new equilibria. In addition, the rule is budget neutral over the medium term, encourages a prudent risk management in the market, and is more resilient to speculative attacks than other rules, such as fixed-volatility rules. The empirical methodology is backtested on Banco Mexico’s FXIs data between 2008 and 2016.

Predictive Density Aggregation: A Model for Global GDP Growth (2020)

IMF Working Paper No. 20/78 with Francesca Caselli, Francesco Grigoli and Changchun Wang (all IMF).

We propose a novel approach to obtain the predictive density of global GDP growth. It hinges upon a bottom-up probabilistic model that estimates and combines single countries’ predictive GDP growth densities, taking into account cross-country interdependencies. Specifically, we model non-parametrically the contemporaneous interdependencies across the United States, the euro area, and China via a conditional kernel density estimation of a joint distribution. Then, we characterize the potential amplification effects stemming from other large economies in each region—also with kernel density estimations—and the reaction of all other economies with para-metric assumptions. Importantly, each economy’s predictive density also depends on a set of observable country-specific factors. Finally, the use of sampling techniques allows us to aggregate individual countries’ densities into a world aggregate while preserving the non-i.i.d. nature of the global GDP growth distribution. Out-of-sample metrics confirm the accuracy of our approach.

Growth-at-Risk: Concept and Application in IMF Country Surveillance (2019)

IMF Working Paper No. 19/36 with Changchun Wang and others (all IMF).

The Growth-at-Risk (GaR) framework links current macrofinancial conditions to the distribution of future growth. Its main strength is its ability to assess the entire distribution of future GDP growth (in contrast to point forecasts), quantify macrofinancial risks in terms of growth, and monitor the evolution of risks to economic activity over time. By using GaR analysis, policymakers can quantify the likelihood of risk scenarios, which would serve as a basis for preemptive action. This paper offers practical guidance on how to conduct GaR analysis and draws lessons from country case studies. It also discusses an Excel-based GaR tool developed to support the IMF’s bilateral surveillance efforts.

Fast Trading and the Virtue of Entropy: Evidence from the Foreign Exchange Market (2018)

ECB Working Paper No. 2300 With Giancarlo Corsetti (Cambridge) and Arnaud Mehl (ECB).

Focusing on the foreign exchange reaction to macroeconomic announcements, we show that fast trading is positively and significantly correlated with the entropy of the distribution of quoted prices in reaction to news: a larger share of fast trading increases the degree of diversity of quotes in the order book, for given liquidity, order book depth and size of order flows. Exploiting the WM Reuters’ reform of the fixing methodology in February 2015 as a natural experiment, we provide evidence that fast trading raises entropy, rather than reacting to it. While more entropy in quoted prices means noisier information and arguably complicates price discovery from an individual trader’s perspective, we show that, in the aggregate, more entropy actually brings traded prices closer to the random walk hypothesis, and improves indicators of market efficiency and quality of trade execution. We estimate that a 10 percent increase in entropy reduces the negative impact of macro news by over 60% for effective spreads, against over 40% for realized spreads and price impacts. Our findings suggest that high-frequency quoting may have desirable effects on market performance, specifically stemming from enhanced heterogeneity in trading patterns.

Can Countries Manage Their Financial Conditions Amid Globalization? (2018)

IMF Working Paper No. 18/15 with Nicolas Arregui, Selim Elekdag, Gaston Gelos and Dulani Seneviratne (all IMF).

This paper examines the evolving importance of common global components underlying domestic financial conditions. It develops financial conditions indices (FCIs) that make it possible to compare a large set of advanced and emerging market economies. It finds that a common component, “global financial conditions,” accounts for about 20 percent to 40 percent of the variation in countries’ domestic FCIs, with notable heterogeneity across countries. Its importance, however, does not seem to have increased markedly over the past two decades. Global financial conditions loom large, but evidence suggests that, on average, countries still appear to hold considerable sway over their own financial conditions—specifically, through monetary policy. Nevertheless, the rapid speed at which foreign shocks affect domestic financial conditions may also make it difficult to react in a timely and effective manner, if deemed necessary.

Thick vs. Thin-Skinned: Technology, News, and Financial Market Reaction (2017)

IMF working paper No. 17/91 with Barry Eichengreen (Berkeley) and Arnaud Mehl (ECB)

We study the impact of technology on the reaction of financial markets to information, focusing on the foreign exchange market. We contrast the “thin-skinned” view that technological improvements cause markets to react more to new information with the “thick-skinned” view that they react less. We pinpoint exogenous technological changes using the timing of the connection of countries via the submarine fiber-optic cables used for electronic trading. Cable connections dampen the response of exchange rates to macroeconomic news, consistent with the “thick-skinned” hypothesis. This is in line with the view that technology eases access to information and reduces trend-following behavior. According to our estimates, cable connections reduce the reaction of exchange rates to U.S. monetary policy news by 50 to 80 percent.

Understanding Household Savings in China: the Role of the Housing Market & Borrowing Constraints (2013)

MPRA Paper No. 44611 with Matthieu Bussière (Banque de France), Yannick Kalantzis (Banque de France) and Terry Sicular (Western Ontario)

This paper examines the role of rising housing prices and borrowing constraints as determinants of China’s high household saving rate, especially among young households. Using a life-cycle model of saving behavior in the presence of borrowing constraints, we show that the relationship between housing prices and saving exists only under certain conditions and for certain groups of households. Specifically, when the return on financial instruments is low (which is the case in China), the saving rate of young households may increase with housing prices. This relationship, moreover, is non- linear and depends on the level of wealth. Employing an empirical strategy motivated by the theoretical model, we analyze a dataset of over six thousand Chinese urban households spanning the years 1995, 2002 and 2007. We find evidence that higher housing prices do in fact increase the saving rates of young households. We also find evidence for the predicted non-linearity.

Policy Publications

ECB Bulletin: High-Frequency Trading, Information and Market Volatility: the Role of High-Frequency Quoting and Dark Pools (2016)

Macroprudential Bulletin 2016, Chapter 3, vol 2, European Central Bank

ECB IRE: The Role of Currency Invoicing for the International Transmission of Exchange Rate Movements (2015)

The International Role of The Euro 2015, Special Feature (with Johannes Grab), European Central Bank

Romain Lafarguette