Financial Intermediation and the Costs of Trading in an Opaque Market

Richard C. Green, Burton Hollifield () and Norman Schurhoff

No 2004-11, GSIA Working Papers from Carnegie Mellon University, Tepper School of Business

Abstract: Municipal bonds trade in opaque, decentralized broker-dealer markets in which price information is costly to gather. Whether dealers in such a market operate competitively is an empirical issue, but a difficult one to study because data in such markets is generally not centrally recorded. We analyze a comprehensive database of all trades between broker-dealers in municipal bonds and their customers. The data is only released to the public with a substantial lag, and thus the market was relatively opaque to the traders themselves during our sample period. We use our sample to estimate the cross-sectional determinants of the dealer markups. We find that dealers earn lower average markups on larger trades with customers, even though larger trades lead the dealers to bear more risk of losses. We formulate and estimate a simple structural bargaining model that allows us to estimate measures of leader bargaining power and relate it to characteristics of the trades. The results suggest dealers exercise substantial market power in their trades with customers. Our measures of market power decrease in trade size and in variables that indicate the complexity of the trade for the dealer.

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Working Paper: Financial Intermediation and the Costs of Trading in an Opaque Market (2005)
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