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

Author(s): Harald Hau, William Killeen, Michael J Moore
Publication Date: July 2000
Keyword(s): Microstructure, Spreads, Transaction Costs, Vehicle Currency
JEL(s): F33, G15
Programme Areas: International Macroeconomics, Financial Economics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=2510

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.