Working Paper: CEPR ID: DP9271
Authors: Ana Babuš; Péter Kondor
Abstract: We model trading and information diffusion in OTC markets, when dealers can engage in many bilateral transactions at the same time. We show that information diffusion is effective, but not efficient. While each bilateral price partially reveals all dealers' private information after a single round of trading, dealers could learn more even within the constraints imposed by our environment. This is not a result of dealers' market power, but arises from the interaction between decentralization and differences in dealers' valuation of the asset. We apply our framework to confront several explanations for the disruption of OTC markets with stylized facts from the empirical literature. We find more support for narratives emphasizing increased counterparty risk as opposed to increased informational frictions.
Keywords: bilateral trading; demand schedule; equilibrium; information aggregation; networks; over-the-counter markets
JEL Codes: D82; D85; G14
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| decentralized trading strategies (G13) | information diffusion (D85) |
| inefficiency in information diffusion (D83) | dealers learning from bilateral transactions (L14) |
| systematic distortion in information diffusion (D83) | structure of the trading network (L14) |
| narratives emphasizing increased counterparty risk (F65) | observed disruptions in OTC markets during the financial crisis (E44) |