Trading with Expert Dealers

Abstract

We model investors' allocation of order flow across over-the-counter dealers jointly with dealers' acquisition of expertise that can be used to take advantage of investors across transactions.  Ceteris paribus, investors benefit from allocating their order flow to dealers expected to intermediate large volumes of transactions and to acquire low levels of expertise, whereas dealers profit more from acquiring expertise when intermediating large volumes of transactions.  Our model's equilibrium rationalizes why the most sought-after dealers are often those with the best data, technology, and skills, despite the significant adverse selection concerns triggered by their superior expertise.

Keywords: OTC networks, financial intermediation, dealers, trading skills.

JEL Classification: G20, G14, D82, D43, L13