Frictional Intermediation in Over-the-counter Markets
We extend Duffie, Garleanu, and Pedersen’s (2005) search-theoretic model of over-the-counter asset markets, allowing for a decentralized inter-dealer market with arbitrary heterogeneity in dealers’ valuations or inventory costs. We develop a solution technique that makes the model fully tractable and allows us to derive, in closed form, theoretical formulas for key statistics analyzed in empirical studies of the intermediation process in OTC market. A calibration to the market for municipal securities reveals that the model can generate trading patterns and prices that are quantitatively consistent with the data. We use the calibrated model to compare the gains from trade that are realized in this frictional market with those from a hypothetical, frictionless environment, and to distinguish between the quantitative implications of various types of heterogeneity across dealers.
This paper merges and extends three earlier working papers of ours, Hugonnier (2012), Lester and Weill (2013), and Hugonnier, Lester, and Weill (2014). The present version is dated August 13, 2018. We thank, for fruitful discussions and suggestions, Gadi Barlevy, Julien Cujean, Jaksa Cvitanic, Darrell Duffie, Rudi Fahlenbrach, Mahyar Kargar, Shuo Liu, Semyon Malamud, Thomas Mariotti, Artem Neklyudov, Ezra Oberfield, Re ́my Praz, Guillaume Rocheteau, Mengbo Zhang, and seminar participants at the 2012 Gerzensee workshop on Search and Matching in Financial Markets, the 2012 Bachelier workshop, the 2013 AFFI Congress, EPFL, the University of Lausanne, the Federal Reserve Bank of Philadelphia, the 2014 SaM Conference in Edinburgh, the 2014 conference on Recent Advances in OTC Market Research in Paris, Royal Holloway, UCL, CREST, the 2014 KW25 Anniversary conference, the 2014 Summer Workshop on Money, Banking, Payments and Finance at the Chicago Fed, the Fall 2014 SaM Conference in Philadelphia, the Wharton macro lunch seminar, the University of Chicago, Yale University, Carnegie Mellon University, Cornell University, the Desautels Faculty of Management at McGill University, the McCombs School of Business at UT Austin, the Fall 2014 meeting of the Finance Theory Group, UC Irvine, the Kellogg School of Management, UNC Kenan-Flagler Business School, the 2015 Trading and post-trading conference at the Toulouse School of Economics, the 2016 SED Meeting in Toulouse, UC Riverside, UC Davis, Stanford University, Erasmus University, University of Lugano, and EDHEC. The views expressed here are those of the authors and do not necessarily reflect the views of the Federal Reserve Bank of Philadelphia or the Federal Reserve System. This project was started when Pierre-Olivier Weill was a visiting professor at the Paris School of Economics, whose hospitality is gratefully acknowledged. Financial support from the Swiss Finance Institute is gratefully acknowledged by Julien Hugonnier. The views expressed herein are those of the authors and do not necessarily reflect the views of the National Bureau of Economic Research.
Julien Hugonnier & Benjamin Lester & Pierre-Olivier Weill, 2020. "Frictional Intermediation in Over-the-Counter Markets," The Review of Economic Studies, vol 87(3), pages 1432-1469. citation courtesy of