Working Paper: CEPR ID: DP10708
Abstract: We provide a theory of trading through intermediaries in OTC markets. The role of intermediaries is to sustain unsecured trade. When agents trade without collateral, total surplus can increase. In our model, traders are connected through a network. Agents observe their neighbors' actions, and can trade with their counterparty in a given period through a path of intermediaries in the network. If trade is unsecured, agents can renege on their obligations. We show that trading through a network is essential to support unsecured trade, when agents infrequently meet the same counterparty in the market. However, intermediaries must receive fees to have the incentive to implement unsecured trades. While trade without collateral can be sustained in many networks, the efficiency gains are higher in a star network. The center agent in a star can receive higher fees as well. Moreover, concentrated intermediation is a stable structure, when agents incur linking costs.
Keywords: Dynamic Network Formation; Over-the-Counter Trading; Strategic Default
JEL Codes: D85; G14; G21
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Intermediaries (L14) | Unsecured trade (F19) |
| Intermediaries (L14) | Terms of trade (F14) |
| Star network (D85) | Efficiency of trade (F12) |
| Concentrated intermediation (G29) | Efficiency and stability (C62) |
| Higher investment (G31) | Expected surplus (D81) |
| Higher investment (G31) | Linking costs (D23) |
| Star network (D85) | Expected welfare (D69) |
| Linking costs (F12) | Agents' incentives to engage in trade (D82) |