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Financial intermediation and the role of price discrimination in a two-tier market

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Author Info
Reitz, Stefan
Schmidt, Markus A.
Taylor, Mark P.

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Abstract

Though unambiguously outperforming all other financial markets in terms of liquidity, foreign exchange trading is still performed in opaque and decentralized markets. In particular, the two-tier market structure consisting of a customer segment and an interdealer segment to which only market makers have access gives rise to the possibility of price discrimination. We provide a theoretical foreign exchange pricing model that accounts for market power considerations and analyze a database of the trades of a German market maker and his cross section of end-user customers. We find that the market maker generally exerts low bargaining power vis-á-vis his customers. The dealer earns lower average spreads on trades with financial customers than commercial customers, even though the former are perceived to convey exchange-rate-relevant information. From this perspective, it appears that market makers provide interdealer market liquidity to end-user customers with cross-sectionally differing spreads.

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Paper provided by Deutsche Bundesbank, Research Centre in its series Discussion Paper Series 1: Economic Studies with number 2009,13.

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Date of creation: 2009
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Handle: RePEc:zbw:bubdp1:7582

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Related research
Keywords: foreign exchange; market microstructure; pricing behavior;

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