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The Risk Sharing BenefiÂ…t versus the Collateral Cost: The Formation of the Inter-Dealer Network in Over-the-Counter Trading

Author

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  • Zhuo Zhong

    (University of Melbourne)

  • Kei Kawakami

    (University of Melbourne)

Abstract

The decentralized over-the-counter (OTC) market generates a trading network among dealers. We model the driver behind the formation of this inter-dealer network as the need for dealers to share risk. The trade-o¤ between the benefit of risk-sharing and the funding cost of collateral determines the shape of the inter-dealer network. In equilibrium, dealers’ markups and trading volumes increase with the number of links they have to other dealers, whereas dealers’inventory risks decrease as they form links. In addition, when capacity of providing liquidity differentiates dealers, the network formed exhibits the empirically observed core-periphery structure: dealers with large capacity comprise the core of the network, connecting them to all other dealers, while dealers who have small capacity operate at the periphery. The model matches recent empirical findings on the negative relationship between order sizes and markups. More importantly, we show that there may be structural breaks in this negative relationship as variations in order sizes may alter the inter-dealer network. These results suggest that empirical studies on OTC markets should control for the stability of an inter-dealer network to avoid model misspeci…cation.

Suggested Citation

  • Zhuo Zhong & Kei Kawakami, 2016. "The Risk Sharing BenefiÂ…t versus the Collateral Cost: The Formation of the Inter-Dealer Network in Over-the-Counter Trading," 2016 Meeting Papers 822, Society for Economic Dynamics.
  • Handle: RePEc:red:sed016:822
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    Cited by:

    1. Chung-Yi Tse & Yujing Xu, 2021. "Inter-Dealer Trades in OTC Markets - Who Buys and Who Sells?," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 39, pages 220-257, January.
    2. Andrea Eisfeldt & Bernard Herskovic & Sriram Rajan & Emil Siriwardane, 2018. "OTC Intermediaries," Working Papers 18-05, Office of Financial Research, US Department of the Treasury.
    3. Andrea Eisfeldt & Bernard Herskovic & Emil Siriwardane & Sriram Rajan, 2019. "OTC Intermediaries," 2019 Meeting Papers 204, Society for Economic Dynamics.
    4. Naomi Boyd & Peter Locke & Li Sun, 2020. "Trader networks and options risk management," Journal of Futures Markets, John Wiley & Sons, Ltd., vol. 40(7), pages 1031-1048, July.

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