Competing for Order Flow in OTC Markets

We 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 speed--and investors direct their orders toward dealers that offer the most attractive terms. We characterize the equilibrium in a general setting, and illustrate how the model can account for several important trading patterns in over-the-counter markets which do not emerge from existing models. We then study two special cases which allow us to highlight the differences between these existing models, which assume investors engage in random search for dealers and then use ex post bargaining to determine prices, and our model, which utilizes the concept of competitive search in which dealers post terms of trade. Finally, we calibrate our model, illustrate that it generates reasonable quantitative outcomes, and use it to study how trading frictions affect the per-unit trading costs that investors pay in equilibrium.