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Bid-Ask Spreads in OTC Markets

Author

Listed:
  • Carol Osler

    (Brandeis University)

  • Geir Bjonnes

    (Norwegian Business School)

  • Neophytos Kathitziotis

    (University of Hamburg)

Abstract

According to well-accepted theory, the three primary components of bid-ask spreads reflect operating costs, inventory costs, and adverse selection. We challenge the idea that the traditional trinity applies in all markets, arguing that OTC spreads include a price discrimination component rather than an adverse-selection component. Because OTC trades are not anonymous, OTC dealers will price discriminate according to their clients' information, market sophistication, and trading volume. Adverse selection could influence the information dimension of price discrimination or it could be irrelevant. We support this view with an empirical analysis of transactions data from the world's largest OTC market that include venue and customer IDs. The estimated price discrimination component ranges from two-thirds to six times the combined operating and inventory cost components for different cutomer groups. Adverse selection is irrelevant for most customer groups, and its contribution to spreads paid by the other two customer groups, hedge funds and customer banks, is small in absolute terms but large relative to their average markup. We indentify two structural determinants of the relevance of adverse selection: the presence of an active interdealer market and a customer's engagement in HFT.

Suggested Citation

  • Carol Osler & Geir Bjonnes & Neophytos Kathitziotis, 2016. "Bid-Ask Spreads in OTC Markets," Working Papers 102, Brandeis University, Department of Economics and International Businesss School.
  • Handle: RePEc:brd:wpaper:102
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    File URL: http://www.brandeis.edu/economics/RePEc/brd/doc/Brandeis_WP102.pdf
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    References listed on IDEAS

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