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

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

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 University Library of Munich, Germany in its series MPRA Paper with number 15602.

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Date of creation: 30 May 2009
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Handle: RePEc:pra:mprapa:15602
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