DP3359 Reputation-Based Pricing and Price Improvements in Dealership Markets

Author(s): Gabriel Desgranges, Thierry Foucault
Publication Date: May 2002
Keyword(s): market microstructure, non-anonymous trading, reputation and implicit contracts
JEL(s): D82, G14, L14
Programme Areas: Financial Economics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=3359

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.