A Network-Based Analysis of Over-the-Counter Markets

Abstract

I study how intermediation in over-the-counter markets affects the efficiency of resource allocation. I model an over-the-counter market as a trading network in which bilateral prices and agents' decisions to buy, sell, or act as intermediaries are jointly determined in equilibrium. Trading by strategic agents can result in an inefficient equilibrium allocation because bilateral prices depend not only on the private valuations of all agents, but also on the share of the surplus each intermediary receives. When a trading network is not sufficiently dense, the probability that the equilibrium allocation is always efficient tends to zero as the network size increases. I derive an analytical solution for the expected welfare loss and show that it can increase with the density of the trading network. I apply this theoretical framework to show that a large interconnected financial institution can improve efficiency even after accounting for a moral hazard cost due to a possible ex-post bailout. This welfare gain should be considered when deciding whether large financial institutions are too interconnected to exist.