Optimal Transparency in a Dealer Market with an Application to Foreign Exchange

This paper addresses a fundamental tradeoff in the design of multiple-dealer markets. Namely, though greater transparency can accelerate revelation of information in price, it can also impede dealer risk management. If dealers could choose the transparency regime ex-ante, which regime would they choose? We show that dealers prefer incomplete transparency (meaning marketwide order-flow is observed with noise). Slower price adjustment provides time for non-dealers to trade, thereby sharing risk otherwise borne by dealers. At some point, however, further reduction in transparency impedes risk sharing: too noisy a public signal provides non-dealers too little information to induce them to trade.