Working Paper no. 86: The currency that came in from the cold: Capital controls and the information content of order flow

The Central Bank of Iceland has published a research paper analysing how capital controls affect the microstructure of foreign exchange markets, using as a case study the introduction and subsequent removal of capital controls in Iceland. The impact and information content of trades is analysed in a trivariate VAR model of private dealer order flow, Central Bank order flow and the EURISK exchange rate that allows for contemporaneous feedback effects. The results suggest profound effects of capital controls on the FX market microstructure. When capital controls were introduced, volume plummeted, the information content of trading activity declined and became less responsive to macro news. While there is no recovery of trading volume after the capital controls were abolished, the information content and responsiveness of trading activity increased sharply.