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Over-the-Counter Markets

Paper Session

Friday, Jan. 5, 2018 8:00 AM - 10:00 AM

Marriott Philadelphia Downtown, Meeting Room 406
Hosted By: Econometric Society

Why Trade Over-the-counter? When Investors Want Price Discrimination

Chaojun Wang
,
University of Pennsylvania
Tomy Lee
,
University of Toronto

Abstract

Despite the availability of low-cost exchanges, over-the-counter (OTC) trading is pervasive for most assets. We explain the prevalence of OTC trading using a model of adverse selection, in which informed and uninformed investors choose to trade over-the-counter or on an exchange. OTC dealers' ability to price discriminate allows them to imperfectly cream-skim the uninformed investors from the exchange. Assets with lower adverse selection risk are predicted to have a higher fraction of trades over-the-counter, as observed in practice. The presence of an OTC market increases aggregate trade volume and reduces average bid-ask spread; nonetheless, welfare declines when adverse selection risk is low. Surprisingly, for assets that are mostly traded over-the-counter, closing the OTC market improves welfare, providing support for recent regulatory efforts to end OTC trading in such assets.

The Emergence of Market Structure

Maryam Farboodi
,
Princeton University
Robert Shimer
,
University of Chicago
Gregor Jarosh
,
Princeton University

Abstract

What market structure emerges when market participants can choose the rate at which they contact others? We show that traders who choose a higher contact rate emerge as intermediaries, earning profits by taking asset positions that are misaligned with their preferences. Some of them, middlemen, are in constant contact with other traders and so pass on their position immediately. As search costs vanish, traders still make dispersed investments and trade occurs in intermediation chains, so the economy does not converge to a centralized market. When search costs are a differentiable function of the contact rate, the endogenous distribution of contact rates has no mass points. When the function is weakly convex, faster traders are misaligned more frequently than slower traders. When the function is linear, the contact rate distribution has a Pareto tail with parameter 2 and middlemen emerge endogenously. These features arise not only in the (inefficient) equilibrium allocation, but also in the optimal allocation. Moreover, we show that intermediation is key to the emergence of the rest of the properties of this market structure.

Trading Financial Innovation

Ana Babus
,
Federal Reserve Bank of Chicago
Kinda Hachem
,
University of Chicago

Abstract

Standardized financial securities are frequently traded in over-the-counter markets. This is difficult to reconcile with the view that these markets exist to facilitate the trade of customized contracts. We build a model of financial innovation to explain why standardized securities can be traded in decentralized markets. In our set-up, each dealer designs a security which specifies a payoff for every state of the world. The dealer chooses the states in which the payoff is flat and the states in which the payoff is contingent on the realized state of the world. Investors choose which securities to trade, taking into account how their trades may impact the price of each security. The market structure in which a given security is traded is determined endogenously. We characterize which securities are traded in decentralized rather than centralized markets. Our results also have implications for regulations that force all trade to take place in centralized markets.

Platform Trading with an OTC Market Fringe

Jerome Dugast
,
University of Luxembourg
Pierre-Olivier Weill
,
University of California-Los Angeles
Semih Üslü
,
Johns Hopkins University

Abstract

We study the privately and socially optimal participation of investors in a centralized platform or in an over-the-counter (OTC) market. Investors incur costs to trade in the platform, in the OTC market, or in both at the same time. Investors differ from each other in risk-sharing needs and OTC market trading capacities. We show that investors with low risk-sharing needs and large trading capacities endogenously emerge as OTC intermediaries, and have the strongest private incentives to enter the OTC market vs. the trading platform. Investors with strong risk-sharing needs and low trading capacities endogenously emerge as OTC customers, and have the weakest private incentive to enter the OTC market vs. the trading platform. Turning to social welfare, we provide two necessary conditions for customers' private incentives to be excessively large relative to their social contribution. Mandating or subsidizing trade in a centralized venue can be welfare improving only if these conditions are satis ed. First, investors must differ mostly in terms of OTC trading capacities. Second, participation costs must induce exclusive participation decisions. Based on the empirical trading patterns generated by closed-form examples of our model, we argue that the real-world OTC markets might satisfy the conditions under which mandating or subsidizing centralized trade is welfare improving.
JEL Classifications
  • A1 - General Economics