Expertise, Information, and Dealer-intermediated OTC Markets

Abstract

We develop a model of dealer-intermediated over-the-counter (OTC) markets in which customers choose their relationship dealers and dealers choose their levels of expertise, thereby determining the market structure and price informativeness jointly. We find that, in general, multiple equilibria in market structure exist. When public information is scarce or information is costly, the market tends to concentrate on a few dealers who acquire high levels of expertise. Tension arises between social welfare and customers’ gains: although the monopoly dealer market is socially optimal because of the network externality of information production, liquidity customers’ utility is maximized in a duopoly market with two dealers. When dealers differ in information production efficiency, a less efficient dealer can attract more or even all liquidity customers.

Keywords: Dealer, Expertise, Private Information, OTC, Bilateral Trading, Network

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