Dealer Expertise and Market Concentration in OTC Trading

Abstract

In most over-the-counter markets, a few dealers build large research teams and account for major proportions of customer trades. We endogenize dealer expertise and size in a model in which each customer values such expertise and chooses one dealer to trade with. In equilibrium, when a dealer attracts more customers, she acquires more expertise and enjoys greater market power, with the former effect benefiting whereas the latter hurting her customers. Ex ante identical dealers may differ in equilibrium. While social welfare increases with customers’ concentration, customers themselves fare better with intermediate levels of concentration. Improved transparency tends to reduce market concentration.

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

JEL Classification: G11, G12, G21