Endogenous Market Making and Network Formation

Abstract

This paper proposes a theory of intermediation in which intermediaries emerge endogenously as the choice of agents. In contrast to the previous trading models based on random matching or exogenous networks, we allow traders to explicitly choose their trading partners as well as the number of trading links in a dynamic framework. We show that traders with higher trading needs optimally choose to match with traders with lower needs for trade, and they build fewer links in equilibrium. As a result, traders with the least trading need turn out to be the most connected and have the highest gross trade volume. The model therefore endogenously generates a coreperiphery trading network that we often observe: a financial architecture that involves a small number of large, interconnected institutions. We use this framework to study bidask spreads, trading volume, asset allocation. All rights reserved. No part of this publication may be reproduced, stored in a retrieval system or transmitted in any form or by any means without the prior permission in writing of the publisher nor be issued to the public or circulated in any form other than that in which it is published.Requests for permission to reproduce any article or part of the Working Paper should be sent to the editor at the above address. Abstract This paper proposes a theory of intermediation in which intermediaries emerge endogenously as the choice of agents. In contrast to the previous trading models based on random matching or exogenous networks, we allow traders to explicitly choose their trading partners as well as the number of trading links in a dynamic framework. We show that traders with higher trading needs optimally choose to match with traders with lower needs for trade, and they build fewer links in equilibrium. As a result, traders with the least trading need turn out to be the most connected and have the highest gross trade volume. The model therefore endogenously generates a core-periphery trading network that we often observe: a financial architecture that involves a small number of large, interconnected institutions. We use this framework to study bid-ask spreads, trading volume, asset allocation.

The Formation of a Core-Periphery Structure in Heterogeneous Financial Networks

“…3 This paper aims to contribute to our understanding of why such core-periphery networks are formed. This aim is similar to recent work by Castiglionesi andNavarro (2016), Farboodi (2015), Chang and Zhang (2016) and Bedayo et al (2016). Differently from those papers, we aim to understand if such a core-periphery structure may arise endogenously from ex-ante identical banks.…”

“…One may make a distinction between papers that are more concerned with the trade offs between contagion, risk sharing, efficiency and stability (Cabrales et al, 2013;Acemoglu et al, 2014;Babus, 2016), and papers that (among other things) rationalise the formation of a core-periphery structure in financial networks (Farboodi, 2015;Bedayo et al, 2016;Castiglionesi and Navarro, 2016;Chang and Zhang, 2016;Wang, 2016). Our paper belongs to the second category.…”

“…9 In Chang and Zhang (2016) banks are heterogeneous in the volatility of their liquidity needs. More volatile banks trade with more stable banks, creating a multi-tier financial system with the most stable banks in the core.…”

Pricing and Liquidity in Decentralized Asset Markets

“…The steeper line represents the marginal valuation of a slow investor while the ‡atter line represents the marginal valuation of a fast investor. This is the direct result of Equation (13). Since the e¤ective discount rate is decreasing in , the slope of the marginal valuation line is lower for investors with high .…”

“…It is instructive to note that an alternative environment where investors have access to a centralized market at Poisson arrival times with intensity e r ( ) r would lead to the same marginal valuation in (13). After every trade, the trading investor's marginal valuation would be equal to the average marginal valuation of the market.…”