Where to Trade: OTC vs Exchanges

Cecilia Parlatore and Ana Babus
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Ana Babus: Imperial College London

No 1100, 2014 Meeting Papers from Society for Economic Dynamics

Abstract: This paper proposes a theory which explains why some assets are traded over the counter while others are traded in centralized exchanges. We develop a model in which the equilibrium market structure is driven by the differences in the trading needs of investors. In our model, trade takes place sequentially. In the first stage, dealers open trading posts and set their trading strategies. One or more dealers can locate at the same trading post. In the second stage, traders decide which trading post to join depending on how many dealers there are at the respective trading post. We show that dealers compete with each other and, hence, have incentives to avoid sharing trading posts in order to maximize their rents. In equilibrium, however, the heterogeneity in traders' private valuations for the asset determines how the asset is traded. Assets for which traders' private valuations are relatively homogeneous, such as bonds, trade in fragmented markets. In contrast, assets for which traders' private valuations are more widely dispersed, such as stocks, trade in centralized markets. The model also has implications for liquidity and price dispersion.

Date: 2014
New Economics Papers: this item is included in nep-mst
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Persistent link: https://EconPapers.repec.org/RePEc:red:sed014:1100

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