Discriminatory Pricing of Over-the-Counter Derivatives

IMF Working Papers, May 7, 2019

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New regulatory data reveal extensive price discrimination against non-financial clients in the FX derivatives market.
The client at the 90th percentile pays an effective spread of 0.5%.
The bottom quarter incur transaction costs of less than 0.02%.
Dealers charge higher spreads to less sophisticated clients, consistent with models of search frictions in over-the-counter markets.
Price discrimination is eliminated when clients trade through multi-dealer request-for-quote platforms (RFQ platforms).
Dealers extract rents from captive clients and market opacity, but only for contracts negotiated bilaterally with unsophisticated clients.

Market structure and search frictions: Evidence supports frameworks where dealer market power and client search costs lead to heterogeneity in pricing across client types.
Client sophistication: Sophistication is a key determinant of spreads charged; less sophisticated clients face systematically higher effective costs.
Trading venue effects: Use of multi-dealer RFQ platforms reduces or eliminates discriminatory pricing, implying venue-based competition mitigates information rents.
Bilateral negotiation risks: Bilaterally negotiated contracts with unsophisticated clients and opaque market conditions create opportunities for dealers to extract rents.

Promote multi-dealer RFQ platforms to increase competition and reduce discriminatory pricing in FX derivatives for non-financial clients.
Enhance transparency and reduce market opacity to limit information rents that dealers extract from captive or unsophisticated clients.
Target regulatory attention to bilateral OTC contracting practices involving unsophisticated clients to protect against excessive spreads.