Discriminatory Pricing of Over-the-Counter Derivatives

Abstract

New regulatory data reveal extensive price discrimination against non-financialclients in the FX derivatives market. The client at the 90th percentile pays aneffective spread of 0.5%, while the bottom quarter incur transaction costs of lessthan 0.02%. Consistent with models of search frictions in over-the-counter markets,dealers charge higher spreads to less sophisticated clients. However, price discriminationis eliminated when clients trade through multi-dealer request-for-quote platforms.We also document that dealers extract rents from captive clients and marketopacity, but only for contracts negotiated bilaterally with unsophisticated clients.

Keywords: Market interest rates, Credit default swap, Exchange markets, Interest parity, Currency swaps, Transaction costs, search frictions, information rents, RFQ platforms, RFQ, mid-price, counterparties, price adjustment, price discrimination

JEL Classification: G14, G18, D4, F16, E01, G21, E52, E64