Why Trade Over-the-Counter? When Investors Want Price Discrimination

53 Pages Posted: 13 Dec 2017 Last revised: 7 Feb 2019

See all articles by Tomy Lee

Tomy Lee

CEU

Chaojun Wang

University of Pennsylvania - The Wharton School

Multiple version iconThere are 2 versions of this paper

Date Written: February 5, 2018

Abstract

Despite the availability of low-cost exchanges, over-the-counter (OTC) trading is pervasive for most assets. We explain the prevalence of OTC trading using a model of adverse selection, in which informed and uninformed investors choose to trade over-the-counter or on an exchange. OTC dealers' ability to price discriminate allows them to imperfectly cream-skim the uninformed investors from the exchange. Assets with wider bid-ask spreads on exchanges are predicted to have a higher proportion of total volume that is traded on exchanges, as supported by evidence from US stocks. Having an OTC market can reduce welfare while increasing total trade volume and decreasing average bid-ask spread. Specifically, for assets that are mostly traded over-the-counter (such as swaps and bonds), having the OTC market actually harms welfare. Our results justify recent policies that seek to end OTC trading for such assets.

Keywords: Over-the-counter, exchanges, venue choice, price discrimination, adverse selection

JEL Classification: D47, G14, G18, G23

Suggested Citation

Lee, Tomy and Wang, Chaojun, Why Trade Over-the-Counter? When Investors Want Price Discrimination (February 5, 2018). Available at SSRN: https://ssrn.com/abstract=3087647 or http://dx.doi.org/10.2139/ssrn.3087647

Tomy Lee (Contact Author)

CEU ( email )

Nádor u. 13, 408
Budapest, Budapest 1051
Hungary

HOME PAGE: http://https://sites.google.com/view/tomylee/home

Chaojun Wang

University of Pennsylvania - The Wharton School ( email )

3641 Locust Walk
Philadelphia, PA 19104-6365
United States

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