Dealer Expertise and Market Concentration in OTC Trading

Abstract

We endogenize dealer expertise and market structure in a model of over-the-counter markets in which each customer values dealers' expertise in producing information on a risky asset's value and chooses one dealer to trade with. When more customers concentrate in a dealer, the dealer acquires more expertise and also enjoys greater market power, with the former benefiting whereas the latter hurting her customers. Ex-ante identical dealers can differ in expertise level and size in equilibrium. Our model generates a positive association of dealers' expertise, size, and bid-ask spreads they charge. Further, while social welfare increases with customers' concentration, customers themselves fare better with intermediate levels of concentration. In addition, improving transparency tends to lower market concentration, improve liquidity, and reduce price dispersion. Less-efficient dealers can capture larger market shares.

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

JEL Classification: G11, G12, G21