Working Paper: CEPR ID: DP3359
Authors: Gabriel Desgranges; Thierry Foucault
Abstract: In many security markets, dealers trade with their regular clients at a discount relative to prevailing bid and ask quotes. In this article we provide an explanation to this phenomenon. We consider a dealer and an investor engaged in a long-term relationship. The dealer assigns a reputational index to his client. This index increases (reputation decreases) when the client conducts trades which results in a loss for the regular dealer. The dealer grants a price improvement if and only if the client?s index is smaller than a threshold and suspends price improvements otherwise. We show that this pricing strategy induces the investor to refrain from exploiting private information against their regular dealer. We also find that it worsens the quotes posted by other dealers. For this reason, there are cases in which the investor is better off if long-term relationships are impossible (for instance, if trading is anonymous). Our model predicts that a dealer?s decision to grant a price improvement depends on their past trading profits with the trader requesting the improvement.
Keywords: Market microstructure; Non-anonymous trading; Reputation; Implicit contracts
JEL Codes: D82; G14; L14
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Investor's reputational index (G24) | Dealer's decision to grant price improvement (D47) |
| Investor's past trading profits (G11) | Investor's reputational index (G24) |
| Informed trading (G14) | Investor's reputation deterioration (G24) |
| Investor's reputation deterioration (G24) | Investor's chances of receiving price improvements (G19) |
| Long-term relationships (D15) | Adverse selection problems for once-off dealers (D82) |
| Dealer's pricing strategies (D43) | Quotes offered by once-off dealers (L81) |