Endogenous Intermediation in Over-the-Counter Markets

Ana Babus, Tai-Wei Hu

Research output: Working paper

Abstract

We provide a theory of trading through intermediaries in over-the-counter markets. In our model, the role of intermediaries is to sustain unsecured trade. When agents borrow funds to invest in risky projects without pledging collateral, total surplus can increase. We propose a set-up in which traders in the OTC market are connected through a network. Agents observe the actions of their neighbors, and, at the same time, can trade with their counterparty in a given period through a path of intermediaries in the network. Both borrowers and intermediaries can renege on their obligations when trade is unsecured. We show that trading through a network is essential to support unsecured trade, when agents are unlikely to meet the same counteparty again in the market. However, intermediaries must receive fees to ensure they have the incentive to implement unsecured trades. While trade without collateral can be sustained in various classes of networks, we find that the gains from unsecured trade in a star network are higher than in many other networks. The center agent in a star network can receive a higher fee as well. We show that concentrated intermediation is both an efficient and stable structure when agents incur linking costs.
Original languageEnglish (US)
PublisherSocial Science Research Network (SSRN)
Number of pages55
StatePublished - Jun 25 2015

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