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Endogenous Market Making and Network Formation

Author

Listed:
  • Briana Chang

    () (School of Business, University of Wisconsin–Madison;)

  • Shengxing Zhang

    () (Department of Economics, London School of Economics (LSE)
    Centre for Macroeconomics (CFM))

Abstract

This paper proposes a theory of intermediation in which intermediaries emerge endogenously as the choice of agents. In contrast to the previous trading models based on random matching or exogenous networks, we allow traders to explicitly choose their trading partners as well as the number of trading links in a dynamic framework. We show that traders with higher trading needs optimally choose to match with traders with lower needs for trade and they build fewer links in equilibrium. As a result, traders with the least trading need turn out to be the most connected and have the highest gross trade volume. The model therefore endogenously generates a core-periphery trading network that we often observe: a financial architecture that involves a small number of large, interconnected institutions. We use this framework to study bid-ask spreads, trading volume, asset allocation and implications on systemic risk.

Suggested Citation

  • Briana Chang & Shengxing Zhang, 2015. "Endogenous Market Making and Network Formation," Discussion Papers 1534, Centre for Macroeconomics (CFM).
  • Handle: RePEc:cfm:wpaper:1534
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    References listed on IDEAS

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    Citations

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    Cited by:

    1. Hendershott, Terrence & Li, Dan & Livdan, Dmitry & Sch�rhoff, Norman, 2017. "Relationship Trading in OTC Markets," CEPR Discussion Papers 12472, C.E.P.R. Discussion Papers.
    2. Batchimeg Sambalaibat, 2018. "Endogenous Specialization and Dealer Networks," 2018 Meeting Papers 1278, Society for Economic Dynamics.
    3. Geromichalos, Athanasios & Herrenbrueck, Lucas, 2016. "The Strategic Determination of the Supply of Liquid Assets," MPRA Paper 71454, University Library of Munich, Germany.
    4. guido menzio & Gregor Jarosch & Maryam Farboodi, 2016. "Tough Middlemen," 2016 Meeting Papers 1371, Society for Economic Dynamics.
    5. Simpson Zhang & Mihaela van der Schaar, 2018. "Reputational Dynamics in Financial Networks During a Crisis," Working Papers 18-03, Office of Financial Research, US Department of the Treasury.
    6. Geromichalos, Athanasios & Herrenbrueck, Lucas, 2016. "The Strategic Determination of the Supply of Liquid Assets," MPRA Paper 71454, University Library of Munich, Germany.
    7. Maryam Farboodi & Gregor Jarosch & Robert Shimer, 2017. "The Emergence of Market Structure," NBER Working Papers 23234, National Bureau of Economic Research, Inc.
    8. Chiu, Jonathan & Monnet, Cyril, 2016. "Relationships in the interbank market," Working Paper Series 5210, Victoria University of Wellington, School of Economics and Finance.
    9. Athanasios, Geromichalos & Kuk Mo, Jung, 2016. "Monetary Policy and Efficiency in Over-the-Counter Financial Trade," MPRA Paper 71455, University Library of Munich, Germany.
    10. Shen, Ji & Wei, Bin & Yan, Hongjun, 2016. "Financial Intermediation Chains in an OTC Market," MPRA Paper 74925, University Library of Munich, Germany.
    11. repec:eee:jfinec:v:125:y:2017:i:1:p:200-215 is not listed on IDEAS
    12. Zafer Kanık, 2017. "Rescuing the Financial System: Capabilities, Incentives, and Optimal Interbank Networks," Working Papers 17-17, NET Institute.
    13. Uslu, Semih, 2015. "Pricing and Liquidity in Decentralized Asset Markets," MPRA Paper 73901, University Library of Munich, Germany, revised 21 Sep 2016.
    14. Batchimeg Sambalaibat & Artem Neklyudov, 2016. "Endogenous Specialization and Dealer Networks," 2016 Meeting Papers 1041, Society for Economic Dynamics.
    15. repec:aea:aecrev:v:107:y:2017:i:11:p:3320-62 is not listed on IDEAS
    16. Babus, Ana & Hu, Tai-Wei, 2017. "Endogenous intermediation in over-the-counter markets," Journal of Financial Economics, Elsevier, vol. 125(1), pages 200-215.
    17. Cestau, Dario & Hollifield, Burton & Li, Dan & Schürhoff, Norman, 2018. "Municipal Bond Markets," CEPR Discussion Papers 13301, C.E.P.R. Discussion Papers.
    18. Garratt, Rodney, 2016. "Centralized netting in financial networks," University of California at Santa Barbara, Economics Working Paper Series qt79t1q6cg, Department of Economics, UC Santa Barbara.

    More about this item

    Keywords

    Over-the-counter Market; Trading Network; Matching; Intermediation;

    JEL classification:

    • C70 - Mathematical and Quantitative Methods - - Game Theory and Bargaining Theory - - - General
    • G1 - Financial Economics - - General Financial Markets
    • G20 - Financial Economics - - Financial Institutions and Services - - - General

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