Working Paper: NBER ID: w20608
Authors: Benjamin Lester; Guillaume Rocheteau; Pierre-Olivier Weill
Abstract: We develop a model of a two-sided asset market in which trades are intermediated by dealers and are bilateral. Dealers compete to attract order flow by posting the terms at which they execute trades-- which can include prices, quantities, and execution speed--and investors direct their orders toward dealers that offer the most attractive terms. We characterize the equilibrium in a general setting, and illustrate how the model can account for several important trading patterns in over-the-counter markets which do not emerge from existing models. We then study two special cases which allow us to highlight the differences between these existing models, which assume investors engage in random search for dealers and then use ex post bargaining to determine prices, and our model, which utilizes the concept of competitive search in which dealers post terms of trade. Finally, we calibrate our model, illustrate that it generates reasonable quantitative outcomes, and use it to study how trading frictions affect the per-unit trading costs that investors pay in equilibrium.
Keywords: OTC markets; order flow; dealer competition; trading costs; market microstructure
JEL Codes: D53; D83; G1; G12
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| dealers' posted terms (L81) | order flow from investors (G24) |
| fraction of investors who can observe posted contracts (G19) | welfare (I38) |
| trade size (F19) | trading costs (F12) |
| structure of the market (D40) | observed trading behaviors (G41) |
| posted terms (Y60) | investor behavior (G41) |