Dealer Expertise and Market Concentration in OTC Trading

Abstract

In most over-the-counter (OTC) 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 can choose one dealer with whom to trade. The equilibrium market structure is driven by two countervailing effects when more customers concentrate in a dealer: the dealer acquires more expertise and enjoys greater bargaining power, with the former effect benefiting and the latter hurting these customers. Multiple equilibria emerge and ex-ante identical dealers may differ substantially in equilibrium. While social welfare always increases when customers concentrate in fewer dealers, customers fare better in equilibria with intermediate levels of concentration. Scarcity of public information tends to intensify market concentration and inefficient dealers can capture more customers.

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

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