Core-Periphery Trading Networks

Abstract

Core-periphery trading networks arise endogenously in over-the-counter markets as an equilibrium balance between trade competition and inventory efficiency. A small number of firms emerge as core dealers to intermediate trades among a large number of peripheral firms. The equilibrium number of dealers depends on two countervailing forces: (i) competition among dealers in their pricing of immediacy to peripheral firms, and (ii) the benefits of concentrated intermediation for lowering dealer inventory risk through dealers' ability to quickly net purchases against sales. For an asset with a lower frequency of trade demand, intermediation is concentrated among fewer dealers, and interdealer trades account for a greater fraction of total volume. These two predictions are strongly supported by evidence from the Bund and U.S. corporate bond markets. From a welfare viewpoint, I show that there are too few dealers for assets with high frequency of trade demand, and too many for assets with infrequent trade demand.

Keywords: Over-the-counter, network, financial intermediation, trade competition, inventory cost, liquidity

JEL Classification: C73, D43, D85, L13, L14, G14