Endogenous Market Making and Network Formation
41 Pages Posted: 29 Apr 2015 Last revised: 22 Feb 2019
Date Written: July 1, 2018
This paper develops a dynamic trading framework that determines jointly agents' counterparties and transaction prices as part of the equilibrium, instead of assuming that agents match and bargain exogenously. We show that because of limited information in the decentralized market, the roles of market makers or customers emerge endogenously: certain agents specialize in market making and become highly interconnected, forming the core of the financial network. Having a model with endogenous trading links and transaction prices allows us to show that such a highly asymmetric market structure is constrained efficient, as market makers are compensated correctly for their services. It also allows us to obtain new insights regarding market resilience and intermediation costs.
Keywords: Trading Network, Over-the-Counter Market, Intermediation
JEL Classification: C70, G1, G20
Suggested Citation: Suggested Citation