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Session Overview
MM-2: OTC Market Pricing
Thursday, 23/Aug/2018:
8:30am - 10:00am

Session Chair: Norman Schürhoff, University of Lausanne, Swiss Finance Institute
Location: Krolewski

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Dealer Spreads in the Corporate Bond Market: Agent vs. Market-Making Roles

Louis Ederington1, Pradeep Yadav1, Wei Guan2

1University of Oklahoma, United States of America; 2University of South Florida St. Petersburg, USA

Discussant: Suresh Sundaresan (Columbia University)

Utilizing subsets of trades in which dealers act purely as agents for customers, purely as market-makers, or in dual capacity, we investigate dealer-spreads arising from dealers’ roles as agents or market-makers. We find that agent-related-spreads are comparable in magnitude to market-making-spreads, and consistent with liquidity-search and customer-interface-costs/benefits; while market-making-spreads are consistent with inventory/asymmetric-information costs. We also find: (a) agent-related spreads are lower in likely automated/semi-automated electronically-executed trades but market-making spreads appear slightly higher, (b) dealers appear to benefit informationally through interfacing directly with customers, and (c) many earlier TRACE studies have underestimated average trading costs by ignoring the separate agent and market-making roles of dealers.

EFA2018-662-MM-2-Ederington-Dealer Spreads in the Corporate Bond Market.pdf

Illuminating the Dark Side of Financial Innovation: The Role of Investor Information

Simon Straumann, Marc Arnold, Manuel Ammann

University of St.Gallen, Switzerland

Discussant: Anton Tsoy (Einaudi Institute for Economics and Finance)

This paper investigates the impact of imperfect investor information on financial innovation. We identify volatility and dividends as specific information sources for which issuers of financially engineered products have an information advantage over retail investors. Issuers' information advantage is crucial to explaining the overpricing and design of financially engineered products. We confirm our conjecture that issuers exploit this information channel by analyzing a discontinuity in issuers' information advantage. The insights are of systemic importance because they suggest that product issuers' behavior in the financial innovation market aggravates investor information frictions in the financial system.

EFA2018-288-MM-2-Straumann-Illuminating the Dark Side of Financial Innovation.pdf

Discriminatory Pricing of over-the-counter Derivatives

Harald Hau1, Peter Hoffmann2, Sam Langfield2, Yannick Timmer3

1University of Geneva, Swiss Finance Institute; 2European Central Bank; 3Trinity College Dublin, Ireland

Discussant: Tomy Lee (Central European University)

New regulatory data reveal extensive discriminatory pricing in the foreign exchange derivatives market, in which dealer-banks and their non-financial clients trade over-the-counter. After controlling for contract characteristics, dealer fixed effects, and market conditions, we find that the client at the 75th percentile of the spread distribution pays an average of 30 pips over the market mid-price, compared to competitive spreads of less than 2.5 pips paid by the bottom 25% of clients. Higher spreads are paid by less sophisticated clients. However, trades on multi-dealer request-for-quote platforms exhibit competitive spreads regardless of client sophistication, thereby eliminating discriminatory pricing.

EFA2018-784-MM-2-Hau-Discriminatory Pricing of over-the-counter Derivatives.pdf

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