Brokers or Dealers? Trading Intermediation and Market Liquidity

Abstract

Investors can execute trades through either brokers that trade on their behalf (agency intermediation) or dealers that trade with them (principal intermediation). We explain the heterogeneity in intermediation via the trade-off between monitoring brokers and incurring dealer inventory costs. Brokers do not internalize execution outcomes and thus require monitoring. Dealers internalize outcomes but face inventory costs. Consistent with model predictions, agency intermediation is more prevalent in transparent and liquid markets; when intermediary capital cost increases, principal intermediation is replaced by agency intermediation. Our theory implies that improving market transparency can alleviate the pressure of tightening capital regulations on market liquidity.

Keywords: Intermediaries, Agency Trading, Principal Trading, Price Benchmark, Market Transparency

JEL Classification: C73, L14, G12