A Theory of Participation in OTC and Centralized Markets

Should regulators encourage the migration of trade from over-the-counter (OTC) to centralized markets?To address this question, we consider a model of equilibrium and socially optimal market participationof heterogeneous banks in an OTC market, in a centralized market, or in both markets at the sametime. We find that banks have the strongest private incentives to participate in the OTC market if theyhave the lowest risk-sharing needs and highest ability to take large positions. These banks endogenouslyassume the role of OTC market dealers. Other banks, with relatively higher risk-sharing needs andlower ability to take large positions, lie at the margin: they are indifferent between the centralizedmarket and the OTC market, where they endogenously assume the role of customers. We show thatmore customer bank participation in the centralized market can be welfare improving only if banksare mostly heterogeneous in their ability to take large positions in the OTC market, and if participationcosts induce banks to trade exclusively in one market. Empirical evidence suggests that these conditionsfor a welfare improvement are met.