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

Though unambiguously outperforming all other ¯nancial markets in terms of liquidity,foreign exchange trading is still performed in opaque and decentralized markets. In par-ticular, the two-tier market structure consisting of a customer segment and an interdealersegment to which only market makers have access gives rise to the possibility of pricediscrimination. We provide a theoretical foreign exchange pricing model that accounts formarket power considerations and analyze a database of the trades of a German marketmaker and his cross section of end-user customers. We ¯nd that the market maker gener-ally exerts low bargaining power vis-¶a-vis his customers. The dealer earns lower averagespreads on trades with ¯nancial customers than commercial customers, even though theformer are perceived to convey exchange-rate-relevant information. From this perspective,it appears that market makers provide interdealer market liquidity to end-user customerswith cross-sectionally di®ering spreads.[...] Stefan Reitz, Markus A. Schmidt, Mark P. Taylor