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Endogenous Market-making and Formation of Trading Links

Author

Listed:
  • Shengxing Zhang

    (London School of Economics)

  • Briana Chang

    (University of Wisconsin Madison)

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.

Suggested Citation

  • Shengxing Zhang & Briana Chang, 2015. "Endogenous Market-making and Formation of Trading Links," 2015 Meeting Papers 1227, Society for Economic Dynamics.
    • Handle: RePEc:red:sed015:1227
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    References listed on IDEAS

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    1. Gara Afonso & Ricardo Lagos, 2015. "Trade Dynamics in the Market for Federal Funds," Econometrica, Econometric Society, vol. 83, pages 263-313, January.
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    3. Lester, Benjamin & Weill, Pierre-Olivier & Hugonnier, Julien, 2022. "Heterogeneity in decentralized asset markets," Theoretical Economics, Econometric Society, vol. 17(3), July.
    4. Maryam Farboodi, 2014. "Intermediation and Voluntary Exposure to Counterparty Risk," 2014 Meeting Papers 365, Society for Economic Dynamics.
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    6. Andrew G. Atkeson & Andrea L. Eisfeldt & Pierre‐Olivier Weill, 2015. "Entry and Exit in OTC Derivatives Markets," Econometrica, Econometric Society, vol. 83, pages 2231-2292, November.
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    Citations

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    Cited by:

    1. Batchimeg Sambalaibat, 2018. "Endogenous Specialization and Dealer Networks," 2018 Meeting Papers 1278, Society for Economic Dynamics.
    2. guido menzio & Gregor Jarosch & Maryam Farboodi, 2016. "Tough Middlemen," 2016 Meeting Papers 1371, Society for Economic Dynamics.
    3. Gofman, Michael, 2017. "Efficiency and stability of a financial architecture with too-interconnected-to-fail institutions," Journal of Financial Economics, Elsevier, vol. 124(1), pages 113-146.
    4. Robert Shimer & Gregor Jarosch & Maryam Farboodi, 2016. "Meeting Technologies in Decentralized Asset Markets," 2016 Meeting Papers 844, Society for Economic Dynamics.

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