A Theory of Participation in OTC and Centralized Markets

Abstract

Should regulators encourage the migration of trade from over-the-counter (OTC) to centralized markets? To address this question, we study a model in which banks make costly decisions to participate in an OTC market, a centralized market, or both markets at the same time. Banks differ in their ability to take large positions, what we call their trading capacity. In equilibrium, intermediate-capacity banks find it optimal to participate in the centralized market. In contrast, low-and high-capacity banks find it optimal to participate in the OTC market, due to an endogenous complementarity. Namely, low capacity banks receive worse terms of trade than in the centralized market but better risk sharing, thanks to the intermediation services offered by high-capacity banks. High-capacity banks receive worse risk sharing than in the centralized market, but profit from the provision of intermediation services to low-capacity banks. While the social optimum has qualitatively similar participation patterns, it prescribes that more customers migrate to the centralized market, and that more dealers enter the OTC market.

Emissions trading with transaction costs

“…20 As a possible way of accounting for these aspects in an ETS, see Dugast et al (2019) for a model where banks optimally choose to participate in over-the-counter or centralized markets, or both. 21 We note that compliance-only trading leads to lower effectiveness and market liquidity relative to more active trading strategies that are more likely to enable learning and thus to reduce information and search costs, an aspect our framework does not capture.…”

Inventory Management, Dealers' Connections, and Prices in Over‐the‐Counter Markets

“…Our paper is also connected to models in which some market participants trade bilaterally (similar to peripheral dealers in our model) and only a subset of them can trade in a centralized trading platform (similar to core dealers). In particular, Dugast, Weill, and Uslu (2019) focus on the decision of whether to connect to the centralized platform and describe conditions under which mandating centralized trading improves welfare. In Dunne, Hau, and Moore (2015), clients trade bilaterally with dealers, who have access to a centralized market.…”