Intermediation, Pricing, and Hedging in OTC Markets

Abstract

This paper studies OTC market pricing through equity total return swaps. I develop a model where a dealer, facing demand for long and short swap exposure, optimizes hedging and sets swap spreads. The model predicts that dealers first hedge internally by offsetting  long and short swap positions, and then hedge any residual exposure in the spot market. Crucially, this generates a spread discontinuity at the dealer level: spreads are determined by a dealer’s funding cost for net long demand and by the asset’s short-selling cost for net short demand. I test this prediction using novel regulatory data on swap trading between U.S. mutual funds’ and broker-dealer banks. Swap spreads exhibit a sharp discontinuity when dealer exposure switches from negative to positive. Dealers entice trades that help offset their existing exposure by offering them 19-29% lower spreads, and dealers’ stock holdings move almost one-to-one with their net swap exposure. A quasi-natural experiment, where a large dealer exits, reveals that reduced competition increases spreads by up to 115% on affected securities.

Keywords: Total return swaps, Intermediation, Brokerage

JEL Classification: G12, G14, G24