Dealer Quid Pro Quo in the Municipal Bond Market

Abstract

Dealers intermediate trades in OTC markets by forming trading networks. We find greater network complexity in the municipal bond market than the typical core-periphery structure. Studying dealer reciprocity - the tendency to repay favors - we observe that reciprocity generally leads to lower markups, as dealers exchange lower markups today for future liquidity. However, in small trading communities, reciprocity can facilitate collusion through quid pro quo arrangements, inflating transaction chain markups. Among high-centrality dealers in large communities, high reciprocity reduces average markups by 80 basis points. Conversely, for low-centrality dealers in small communities, high reciprocity increases markups by 72 basis points. Although only about 2% of transaction chains exhibit patterns suggestive of collusive behavior, these instances significantly influence regression analysis. Controlling for these outliers is essential for accurate estimation of the dealer centrality premium or reciprocity discount in the municipal bond market.

JEL Classification: G12, G14, G24