Dealer Intermediation between Markets

Abstract

Dealers are intermediaries between different market segments. A dealer typically maintains a network of customer relationships (B2C) and simultaneously participates in an inter-dealer market (B2B) which allows him to manage his inventory. We represent this market interface role in a new dynamic model of dealer intermediation between a monopolistic B2C market and a competitive B2B market. Dealers face inventory constraints and adverse selection. We characterize their optimal quote setting and inventory management behaviour in both markets in closed form and show the existence of a unique and stable equilibrium. The model provides new insights into the interdependence of quote quality in the B2C and B2B segment. The model implications are then tested for the European sovereign bond market. We use a new synchronized data set of B2B and B2C quotes and trades. The model can explain (i) the high dispersion of quoted and executed customer prices due to the inventory dependence of optimal quotes, (ii) why this dispersion of B2C quote quality dramatically increases in bond duration, (iii) the more pronounced bid-ask spread deterioration under volatility increases for the inter-dealer market, (iii) why aggregate dealer inventory imbalances coincide with asymmetric execution quality between the bid and ask side in the customer segment. We argue that the alternative explanations of discriminatory dealer pricing based on customer type cannot account for the evidence.