Relationships versus Competition in OTC Markets

Title: Relationships versus Competition in OTC Markets

Abstract: Are relationships compatible with competition? In this paper, I document a relationship friction on a foreign exchange multi-dealer request for quote (RFQ) platform. Firms can only trade with a limited set of connected dealer banks. Banks strategically bid-shade their quotes in a request by a less connected firm, leading to discriminatory pricing. Because relationships are costly and banks engage in trading relationships only if they are profitable, many firms are unable to effectively use the RFQ auction mechanism and impose dealer competition. Hence, firms become locked into a single client-dealer relationship.  Therefore, relationships are required to impose dealer competition, but too much competition makes relationships unprofitable. The results have important policy implications: Opposed to the search theory in OTC trading, which points towards tighter transparency regulation, my results suggest lowering compliance costs to make relationships more profitable, increase dealer competition and improve price quality.