Endogenous Specialization and Dealer Networks

94 Pages Posted: 19 Oct 2015 Last revised: 6 Jul 2023

Date Written: May 23, 2022

Abstract

OTC markets exhibit a core-periphery structure: 10-30 highly interconnected dealers account for a majority of interdealer trades and form the core of the interdealer network, while hundreds of sparsely connected dealers trade infrequently and form the periphery. I build a search-based model of endogenous network formation between dealers and propose that a core-periphery interdealer network arises from specialization. Dealers endogenously specialize in different clients with different trading needs. Some dealers attract clients who trade frequently (e.g., index funds); others attract clients with infrequent trading needs (e.g., pension funds). The dealers specializing in clients with frequent trading needs receive a larger volume of client orders, trade more with other dealers, and, as a result, form the core of the interdealer network. The dealers specializing in clients with infrequent trading needs form the periphery. I also show that accounting for client heterogeneity across dealers (a) challenges standard interpretations and measurements of bid-ask spreads and (b) helps reconcile conflicting evidence on bid-ask spreads and dealer centrality.

Keywords: network formation, core-periphery, clientele effect, specialization, intermediation chains, over-the-counter markets, search frictions

JEL Classification: G10

Suggested Citation

Sambalaibat, Batchimeg, Endogenous Specialization and Dealer Networks (May 23, 2022). Available at SSRN: https://ssrn.com/abstract=2676116 or http://dx.doi.org/10.2139/ssrn.2676116

Batchimeg Sambalaibat (Contact Author)

Princeton University ( email )

Princeton, NJ

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