Asset Heterogeneity, Market Fragmentation, and Quasi-Consolidated Trading

Abstract

Large asset heterogeneity is one of the most salient features of over-the-counter (OTC) markets. We first demonstrate, in a benchmark model, that asset heterogeneity results in market fragmentation, limiting the beneficial network externality of liquidity. We then introduce quasi-consolidated (QC) contract---a mechanism that enables assets of heterogeneous values to be traded at a uniform price---into the benchmark model and show that it increases total trading volume and social welfare by reducing market fragmentation. Nevertheless, the uniform pricing of QC trading leads to a cheapest-to-deliver effect, which harms liquidity for sellers who do not adopt QC trading; it also lowers profits for these sellers and even some sellers who adopt QC trading. Our model lays a foundation for analyzing liquidity and design in OTC markets of heterogeneous assets.

Keywords: Asset Heterogeneity, Corporate Bonds, Quasi-Consolidated Trading, TBA, MBS, Search

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