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

53 Pages Posted: 7 Jun 2018

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: June 7, 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 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

Lee, Tomy and Wang, Chaojun, Why Trade Over-the-Counter? When Investors Want Price Discrimination (June 7, 2018). Paris December 2018 Finance Meeting EUROFIDAI - AFFI. Available at SSRN: https://ssrn.com/abstract=3192484 or http://dx.doi.org/10.2139/ssrn.3192484

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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