Dealers as Information Intermediaries in Over-the-Counter Market

Abstract

We model the role of dealers in information diffusion in over-the-counter (OTC) markets. A dealer maintains relationships with a network of both informed customers who trade to profit from private information pertaining to asset values and risk averse liquidity customers who trade to meet idiosyncratic liquidity needs. Knowing the type of every customer in her relationship network, a dealer in our model serves as an information intermediary by first willingly losing to informed customers to learn information from them and then relaying that information to risk averse liquidity customers through trading. We characterize the effects of a dealer's intermediation-profit driven choice of informativeness on liquidity trading and informational efficiency. We also study how the dealer size affects bid-ask spreads and trading volume, as well as how public information affects the dealers' informativeness.

Keywords: Dealer, Intermediation, Private Information, Decentralization, OTC, Trading, Liquidity

JEL Classification: G1, G11, G12, G21, D83, D53, D61