OPTIMAL TRANSPARENCY IN A DEALER MARKET WITH AN APPLICATION TO FOREIGN-EXCHANGE

This paper addresses a fundamental trade-off in the design of multiple -dealer markets. Namely, though greater transparency can accelerate re velation of information in price, it can also impede dealer risk manag ement. If dealers could choose the transparency regime ex ante, which regime would they choose? We show that dealers prefer incomplete trans parency (meaning marketwide order flow is observed with noise). Slower price adjustment provides time for nondealers to trade, thereby shari ng risk otherwise borne by dealers. At some point, however, further re duction in transparency impedes risk sharing: too noisy a public signa l provides nondealers too little information to induce them to trade. Journal of Economic Literature Classification Numbers: F31, G15. (C) 1 996 Academic Press, Inc.