Trading with Expert Dealers

Abstract

We model investors' allocation of order flow among over-the-counter dealers jointly with dealers' acquisition of expertise useful to take advantage of investors across transactions. Investors choose dealers based on their level of expertise and the liquidity they are expected to provide whereas dealers choose their level of expertise based on the number of transactions they expect to intermediate and the cost of acquiring expertise. Our model rationalizes why the most sought-after dealers often are those with the best data, technology, and skills, despite the significant adverse selection concerns triggered by their expertise.

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

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