Good Clients Gets Better Pricing – Study
Posted by Colin Lambert. Last updated: December 12, 2023
The customer relationship is something often discussed in financial markets (often using cliches), but now a study has sought to empirically show the value of a strong dealer-client relationship – Eva Szalay takes a look
Clients with strong dealer relationships receive 70% better prices from their salespeople than those who enjoy less trust from their banks, according to new research into OTC markets that analysed more than a million RFQs.
In a paper published last month, called “Customers, Dealers and Salespeople: Managing Relationships in Over-the-Counter Markets” the authors concluded that OTC markets should be viewed as a series of repeated games where both cooperation and reputation play an important role in outcomes. In other words, clients that secretly tell multiple dealers that they’re asking for prices exclusively from them, get worse quotes in the long run because trading with them causes banks to suffer large “winner’s curse” losses. This is why banks reward strong relationships with consistently better pricing, which means that OTC markets remain highly-concentrated and sticky, despite the high level of electronification in trading.
The authors argue that this means that OTC markets are able to solve a moral hazard problem that’s impossible for anonymous, centralised exchanges, by providing incentives for clients to behave well. “We find that the dealer quotes repeat customers substantially lower bid-ask spreads. In turn, customers are incentivised to abstain from covertly obtain additional quotes, solving a moral hazard problem,” authors Markus Bak-Hansen and David Sloth write in the paper.
The data showed that clients whom banks rate the highest get 70% lower bid-ask spreads from their banks than those that are ranked worst and they also have an eight percentage point higher chance of receiving a quote. The authors control factors for size and volume and found that there was an equilibrium which best served both the client’s and the dealer’s interest in the long run. “Our findings suggest that OTC markets should be understood through the lens of repeated games, where cooperation and reputation are important,” they add.
“Salespeople play a crucial role in assessing and maintaining client relationships, primarily by their reputation and long-term ability to thread the needle between the conflicting interests of the two parties”
The paper analysed Mifid 2 disclosures from European investment firms and also proprietary, trade-level data from an investment bank. This included over one million timestamped RFQs from institutional clients to the bank’s fixed income division between 2018 and 2022. The data doesn’t include FX, but the paper’s findings are relevant for currency markets to the extent that relationships have material outcomes in bid-ask spreads.
The study argues that salespeople play a crucial role in assessing and maintaining client relationships, primarily by their reputation and long-term ability to thread the needle between the conflicting interests of the two parties: their employer’s and their client’s.
Salespeople are key conduits for large and loyal clients getting better prices and as a result, driving factors in the market remaining highly concentrated in spite of wide-spread electronification. The authors of the study found that highly-ranked clients interact with salespeople who are more centrally placed in the dealer’s hierarchy than others and they leverage their own relationships with traders to get favourable pricing.
Researchers looked at what happens when these salespeople are on holiday and found evidence that “in these situations, traders exploit relationship customers by charging excessively high prices”. This leads the authors to conclude that: “salespeople do in fact play a role in facilitating long term relationships.”
The Full FX View
Studies like this are interesting because they confirm what we all know – if the balance of the relationship between dealer and client is fair and relatively equal, the pricing will show a commensurate improvement.
Ultimately, however, this is as much about the role of the salesperson and their ability to act as a ‘brake’ on the trading desk. One of the features of markets probably since the sales desk was invented, has been a healthy tension between trading and sales – and to an extent what this study also highlights is the need for a fair and balanced relationship there, as well as with the client. It would be instructive to see research into what sort of, if any, sales credit system the dealers ran – is the salesperson rewarded on volume alone, or on value? The former very much leads to increased tension, the latter to a pressing need to work together.
Given the study looked at trades between 2018 and 2022, there is a chance that it would have picked upon a fairly recent change in markets – the use of data and analytics to drive the relationship. That data, especially if viewed across the wider markets business, offers great insight into just how valuable, or otherwise, a client is to the franchise and is the dealer’s way of keeping the client “honest”.
Likewise, more clients are aware of the value of their flow in markets, and can use that data to keep their dealers onside, although as the study points out, the salesperson plays a vital role there!
The benefit of improved data and analytics is that it has taken some of the emotion out of the relationship between both bank and client and dealer and salesperson, but the bottom line is this is still dictated by client behaviour. As Eva points out in the article, clients can lie to their banks about how many competitors they are asking, and while that used to be a successful model some years ago, that very same data and analytics now highlights such behaviour in mark-outs. It has never taken a rocket scientist to work out a clients was “away”, but now there can be empirical evidence that they are and pricing can be adjusted accordingly.
Ultimately, this may signal a reversal in relationship momentum. For many years the dealers, thanks to the market structure, had the upper hand, before the advent of the multi-dealer platform and aggregation technology pushed the needle very much towards the customer. What we are now maybe seeing is, as the authors observe, a shift in behaviour on both sides that may, just may, see the relationship needle sitting where it should.
Based on the data set they analysed, the authors found that 64% of customers did at least 80% of their transactions with just three dealers. These relationships proved to be highly static over the years, with an 87% chance that a top-five bank would retain its position the following year. This concentration is true across asset classes in fixed income.
“Despite [the electronification of] OTC markets, we document that customers overwhelmingly still opt to concentrate most of their trading with a select few important dealers,” the authors say.
The paper found strong evidence that banks’ internal rankings of customers takes into account previous interactions and the outcomes for the dealer and that the “winner’s curse” mechanism is central to these results. These rankings are a key mechanism through which clients are incentivised to behave well.
Dealers quote worse prices when they know that lots of others are competing for the trade. Customers can, however, lie to their counterparties and obtain additional quotes in secret, causing the winning dealer to take mark-to-market losses. Through repeated interactions, also known as the relationship, both parties find their optimal behaviour, the paper observes.
“Our findings suggest that there is a cooperative equilibrium between dealers and customers where customers abstain from engaging in exploitative behaviour and where dealers reciprocate by responding more often to requests to trade and by quoting tighter bid-ask spreads,” the study concludes.