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

  • Stefan Reitz
  • Markus A. Schmidt
  • Mark P. Taylor

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 Kiel Institute for the World Economy in its series Kiel Working Papers with number 1794.

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Length: 40 pages
Date of creation: Sep 2012
Date of revision:
Handle: RePEc:kie:kieliw:1794
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