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. In our model, the dealer knows the type of every customer in her relationship network, so she can play the role of an information intermediary who at first willingly loses to informed customers to learn information from them and then relays that information to risk-averse liquidity customers for profits. We characterize the effects of a dealer's profit-driven choice of informativeness on liquidity trading and informational efficiency. We also study how dealer size affects bid-ask spreads and trading volume as well as how public information affects a dealer's choice of informativeness.

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

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