Why Trade Over-the-Counter? When Investors Want Price Discrimination
53 Pages Posted: 13 Dec 2017 Last revised: 11 Sep 2020
Date Written: February 5, 2018
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: Suggested Citation