Working Paper

Financial Intermediation and the Role of Price Discrimination in a Two-Tier Market

Authors

  • Reitz
  • S.
  • Schmidt
  • M.A.
  • Taylor
  • M.P.
Publication Date

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.

Info

JEL Classification
F31, F41

Key Words

  • Foreign Exchange
  • Market Mictrostructure
  • Pricing Behavior