Firms with revenues or expenses in foreign currency face considerable exchange-rate risk, which can be managed through the use of derivatives such as forward rate contracts (Ito et al. 2015). However, forward contracts are typically negotiated bilaterally between a firm and a dealer bank in the over-the-counter (OTC) market, which is notorious for its lack of price transparency (Atkeson et al. 2014).
In 2009, the G20 committed to reform the OTC market for financial derivatives. The objective was to achieve not only a more robust market structure through central clearing (Vuillemey 2018) but also a fairer and more efficient market through enhanced price transparency (Archarya and Engel 2009, Tavares 2011). More than a decade later, the second reform objective remains an unfulfilled promise for foreign exchange (FX) derivatives. Policies to improve market transparency are fiercely opposed by dealer banks and their industry association, which denounces them as ‘cumbersome’ and ‘of little value’ in a lobbying effort to stymie reform (Szalay 2019).
In a new paper (Hau et al. 2021), we use newly available regulatory data to precisely measure the extent of price discrimination against non-financial clients in the FX derivatives market. Using more than half a million transactions among 204 banks and 10,087 non-financial clients in the euro/US dollar forward market, we contribute to a policy debate dominated by anecdotes and (self-serving) assertions rather than data and measurement.
The 10,087 clients analysed range from large multinationals to small import-export companies that use FX derivatives only occasionally. Firms thus vary considerably in their degree of financial sophistication, which can be measured in different ways, such as the number of annual derivatives trades, the overall trading volume, and so on.
Who gets a bad deal in OTC markets?
First, price discrimination against non-financial companies is particularly pronounced among small bank customers, who lack financial expertise. We find that the same bank charges significantly larger effective spreads (a widely used measure of execution costs) to its less-sophisticated customers compared to more sophisticated clients who trade on the same day. How sophistication is defined makes very little difference for establishing this finding. Our analysis suggests that the OTC market for FX derivatives is no level playing field; smaller and peripheral market participants incur considerably higher costs for the same trade.
Second, the nature of bank relationships is crucial to execution quality. Whenever firms trade with a single bank, their bargaining power is low and they find it difficult to even obtain a good price quote for their desired contract. Being able to signal to a dealer the option to trade through other banks tends to reduce the client’s spread by more than one-third. Every additional bank relationship reduces the spread further, as shown in Figure 1.
Figure 1 Average client spread by number of counterparties
Notes: This figure plots the average spread paid by clients with a given number of counterparties in the euro/US dollar forwards market. Marker size is proportional to aggregate notional traded. Marker labels indicate the percentage of clients with a given number of counterparties. For readability, the 17+ counterparty group aggregates all clients with 17 or more counterparties.
Third, price discrimination is very pervasive throughout the OTC market. The median client pays 10.9 pips relative to the largest blue-chip companies because of price discrimination, which is 58% above the mean spread of 6.9 pips, and considerably more than a competitive spread of usually less than 2 pips.1
These large cost differentials can explain why many firms refrain from hedging their FX exposure and especially so in countries with less-developed derivative markets. This gives rise to currency mismatches on corporate balance sheets and increases the variability of corporate profits. Thus, non-participation in the FX market is not without welfare costs to the real economy.
How can firms get a better FX deal?
Short of forcing OTC trading onto exchanges, more incremental reform of OTC markets may also provide large benefits. We find that price discrimination is fully eliminated when clients trade electronically on multi-dealer electronic platforms (e.g. 360T, FXall, Bloomberg, Currenex). These platforms enable clients to request quotes from multiple dealers simultaneously rather than individual dealers sequentially, forcing banks into competition. On such platforms, trades exhibit significantly tighter spreads, and discrimination based on sophistication is entirely eliminated, as can be seen in Figure 2.
Figure 2 Average client spread by sophistication and platform use
Notes: This figure plots the average spread paid by each client (on the vertical axis) against sophistication (on the horizontal axis). Sophistication is the first principal component of various measures capturing client trading intensity. Clients using a platform at least once in our sample period are marked by red crosses; clients that never use a multi-dealer platform are marked by blue dots. The solid line plots the estimated kernel-weighted local polynomial regression of average client spread on sophistication for the subset of clients that never trade on a platform. The dashed line plots the same regression for the subset of clients that trade on a platform at least once during our sample period. For readability, the vertical axis is truncated at -10 pips.
Unfortunately, 90% of corporate clients never trade on a multi-dealer platform. The estimated cost savings amount to approximately €158 million per year in the US dollar/euro market alone and are potentially even higher in less liquid markets. The fact that non-financial firms do not realise these savings can only be partially explained by the costs of adopting multi-dealer platform trading. Incomplete knowledge, namely firms not fully understanding the benefits of platform trading, is likely to play an important role.
Greater (post-trade) transparency on execution prices in the OTC market would enable clients to better compare the costs of different trading mechanisms – thus facilitating convergence to a more efficient market structure. This would not only reduce price discrimination for existing bank clients, but also spur additional market participation and hedging activity by firms that find the current OTC market too costly.
Acharya, V, and R Engle (2009), “A case for (even) more transparency in the OTC markets”, VoxEU.org, 29 August.
Atkeson, A, A Eisfeldt, P-O Weill (2014), “Entry and exit in OTC derivatives markets”, VoxEU.org, 17 September.
Hau, H, P Hoffmann, S Langfield and Y Timmer (2021), “Discriminatory pricing of over-the-counter derivatives”, Management Science 67(11): 6660–77.
Ito, T, S Koibuchi, K Sato and J Shimizu (2015), “How do Japanese exporters manage their exchange rate exposure?”, VoxEU.org, 29 June.
Tavares, C (2011), “Short selling and OTC derivatives policy options”, VoxEU.org, 9 January.
Vuillemey, G (2018), “The real effects of mitigating counterparty risk: Evidence from 19th century France”, VoxEU.org, 17 November.
1 A pip is equal to 0.0001. For the euro/US dollar rate, it corresponds roughly to a basis point (or 0.01%) of the notional amount (i.e. the insured amount).