Competing for Order Flow in OTC Markets

50 Pages Posted: 20 Mar 2014

See all articles by Benjamin R. Lester

Benjamin R. Lester

Federal Reserve Banks - Federal Reserve Bank of Philadelphia

Guillaume Rocheteau

Federal Reserve Bank of Cleveland; National University of Singapore (NUS)

Pierre-Olivier Weill

University of California, Los Angeles; National Bureau of Economic Research (NBER)

Multiple version iconThere are 2 versions of this paper

Date Written: March 13, 2014

Abstract

The authors develop a model of a two-sided asset market in which trades are intermediated by dealers and are bilateral. Dealers compete to attract order flow by posting the terms at which they execute trades, which can include prices, quantities, and execution times, and investors direct their orders toward dealers that offer the most attractive terms of trade. Equilibrium outcomes have the following properties. First, investors face a trade-off between trading costs and speeds of execution. Second, the asset market is endogenously segmented in the sense that investors with different asset valuations and different asset holdings will trade at different speeds and different costs. For example, under a Leontief technology to match investors and dealers, per unit trading costs decrease with the size of the trade, in accordance with the evidence from the market for corporate bonds. Third, dealers’ implicit bargaining powers are endogenous and typically vary across sub-markets. Finally, the authors obtain a rich set of comparative statics both analytically, by studying a limiting economy where trading frictions are small, and numerically. For instance, the authors find that the relationship between trading costs and dealers’ bargaining power can be hump-shaped.

Keywords: Over-the-counter markets, OTC Markets, Order Flow

Suggested Citation

Lester, Benjamin R. and Rocheteau, Guillaume and Weill, Pierre-Olivier, Competing for Order Flow in OTC Markets (March 13, 2014). FRB of Philadelphia Working Paper No. 14-9, Available at SSRN: https://ssrn.com/abstract=2411032 or http://dx.doi.org/10.2139/ssrn.2411032

Benjamin R. Lester (Contact Author)

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Guillaume Rocheteau

Federal Reserve Bank of Cleveland ( email )

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Pierre-Olivier Weill

University of California, Los Angeles ( email )

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National Bureau of Economic Research (NBER)

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