Inventory Management, Dealers’ Connections, and Prices in OTC Markets

Abstract

We propose a new model of interdealer trading. Dealers trade together to reduce their inventory holding costs. Core dealers share these costs efficiently and provide liquidity to peripheral dealers, who have heterogeneous access to core dealers. We derive predictions about the effects of peripheral dealers' connectedness to core dealers and the allocation of aggregate inventories between core and peripheral dealers on the distribution of interdealer prices, the efficiency of interdealer trades, and trading costs for the dealers' clients. For instance, the dispersion of interdealer prices is higher when fewer peripheral dealers are connected to core dealers or when their aggregate inventory is higher.