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Endogenous Market-making and Formation of Trading Links

Shengxing Zhang and Briana Chang
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Shengxing Zhang: London School of Economics
Briana Chang: University of Wisconsin Madison

No 1227, 2015 Meeting Papers from Society for Economic Dynamics

Abstract: This paper develops a dynamic matching model to analyze the equilibrium trading structure in OTC markets. All traders have the same trading technology, and they optimally choose whom to connect to as well as whether to remain active in each period. We show that traders with more volatile preference (i.e. with higher needs for trade) always choose to match with traders with more stable preference (i.e., with less needs for trade) and they also leave the market earlier. The model therefore endogenously generates a core-periphery market structure, where traders with less trading needs develop more trading links in equilibrium and act like market makers. As the role of market-making is endogenous, we therefore provide an answer to why customers choose to trade with dealers instead of trading among themselves, and we can analyze how the market-making profit depends on underlying frictions.

Date: 2015
New Economics Papers: this item is included in nep-dge and nep-mst
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