Why Trade Over-the-Counter? When Investors Want Price Discrimination
53 Pages Posted: 7 Jun 2018
Date Written: June 7, 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 a higher share of trades executed on exchanges are predicted to have wider bid-ask spreads on those 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 in such assets.
Keywords: Over-the-counter, exchanges, venue choice, price discrimination, adverse selection
JEL Classification: D47, G14, G18, G23
Suggested Citation: Suggested Citation