The Market for OTC Derivatives
We develop a model of equilibrium entry, trade, and price formation in over-the- counter (OTC) markets. Banks trade derivatives to share an aggregate risk subject to two trading frictions: they must pay a fixed entry cost, and they must limit the size of the positions taken by their traders because of risk-management concerns. Although all banks in our model are endowed with access to the same trading technology, some large banks endogenously arise as "dealers," trading mainly to provide intermediation services, while medium sized banks endogenously participate as "customers" mainly to share risks. We use the model to address positive questions regarding the growth in OTC markets as trading frictions decline, and normative questions of how regulation of entry impacts welfare.
We'd like to thank, for fruitful discussions and suggestions, Gara Afonso, Saki Bigio, Briana Chang, Darrell Duffie, Ben Lester, Gustavo Manso, Tyler Muir, Martin Oehmke, Ionid Rosu, Tano Santos, Daniel Sanches, Martin Schneider, Shouyong Shi, Randy Wright, Pierre Yared, and seminar participants at UC Davis, UT Austin, Carnegie-Mellon University, OSU, Kellogg, UCLA, LSE, LBS, the Society for Economic Dynamics, Paris School of Economics, NBER Summer Institute, Minnesota Workshop in Macroeconomic Theory, the Chicago Fed Summer Workshop on Money, Banking, Payments and Finance, the AMSE Marseille Macroeconomic Meeting, the Saint Louis Fed Policy Conference, the Wisconsin School of Business in Madison, the American Economic Association, Cal Tech, Banque de France, and Columbia. Patrick Kiefer, Omair Syed, and Alfredo Reyes provided expert research assistance. We thank the Bank of France, the Fink Center for Finance and Investments, and the Ziman Center for Real Estate, for financial support. The views expressed herein are those of the authors and do not necessarily reflect the views of the National Bureau of Economic Research.
Andrea L. Eisfeldt
I conduct compensated financial research for a hedge fund.