Platform Trading with an OTC Market Fringe
Pierre-Olivier Weill () and
Semih Üslü ()
No 1002, 2018 Meeting Papers from Society for Economic Dynamics
We study the privately and socially optimal participation of investors in a centralized platform or in an over-the-counter (OTC) market. Investors incur costs to trade in the platform, in the OTC market, or in both at the same time. Investors differ from each other in risk-sharing needs and OTC market trading capacities. We show that investors with low risk-sharing needs and large trading capacities endogenously emerge as OTC intermediaries, and have the strongest private incentives to enter the OTC market vs. the trading platform. Investors with strong risk-sharing needs and low trading capacities endogenously emerge as OTC customers, and have the weakest private incentive to enter the OTC market vs. the trading platform. Turning to social welfare, we provide two necessary conditions for customers’ private incentives to be excessively large relative to their social contribution. Mandating or subsidizing trade in a centralized venue can be welfare improving only if these conditions are satisfied. First, investors must differ mostly in terms of OTC trading capacities. Second, participation costs must induce exclusive participation decisions. Based on the empirical trading patterns generated by closed-form examples of our model, we argue that the real-world OTC markets might satisfy the conditions under which mandating or subsidizing centralized trade is welfare improving.
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