"Trading and Information Diffusion in Over-the-Counter Markets." (with Peter Kondor)
This paper provides a theory of endogenous intermediation in over-the-counter markets. Intermediation arises to allow agents that meet infrequently to trade risky assets without collateral. Since the chance of meeting the same counterparty in the future is very small, an agent chooses to develop a long-term relationship with another trader who then acts as an intermediary. A relationship between two traders enables them to condition current and future terms of trade on information they have about past transactions. Two forces drive agents' decisions to form relationships. First, gathering information about counterparties is costly. Second, if agents intermediate transactions between others, they require to be compensated for it. A trade-off between forming many relationships and trading through intermediaries arises. Although agents are ex-ante symmetric, in equilibrium a central broker-dealer intermediates all the trade in the market. In addition, I show that the benefit of trading through relationships decreases with the relative difference between the expected return of the assets and the opportunity cost of collateral, and increases in liquid markets.
