Federal Reserve Board
University of Lausanne; Swiss Finance Institute; Centre for Economic Policy Research (CEPR)
March 15, 2012
We use the MSRB Transaction Reporting System audit trail to study the impact of dealer centrality on trading costs and liquidity provision in opaque over-the-counter markets. The dealership network in municipal bonds exhibits a hierarchical core-periphery structure with around 30 highly interconnected dealers at its core and several hundred peripheral dealer firms. Execution quality varies significantly across dealers depending on their centrality within the trading network. Central dealers charge larger trading costs to investors and face lower loss probabilities than peripheral dealers. Yet, more investor orders flow through central dealers. Informational efficiency increases with centrality, mitigating adverse selection risk. Dealers experience significant liquidity spillover from connected dealers, leading central dealers to hold larger and more volatile inventories on average and to keep bonds longer than peripheral dealers. Centrality thereby improves dealers' negotiating position with investors. This explains why competition is fierce at the periphery but not at the core of the decentralized market. These results demonstrate the trade-offs investors face when trading in over-the-counter markets, which may guide financial market design.
Number of Pages in PDF File: 46
Keywords: Municipal bond market, over-the-counter financial market, market quality, liquidity spillover, network analysis
JEL Classification: G12, G14, G24working papers series
Date posted: March 16, 2012
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