Risk Concentration and Interconnectedness in OTC Markets

Abstract

We analyze the impact of a regulatory reform in a novel framework that jointly determines banks’ bilateral networks and platform access. In our model, banks use their bilateral connections to obtain indirect access to the platform, which saves direct entry costs but results in risk concentration. This trade-off leads to a unique market structure, which is generally asymmetric with multiple layers even if all banks are ex ante homogeneous. Policies that increase balance sheet costs relative to entry costs could result in a more symmetric market structure but have ambiguous effects on transaction costs. Our results underscore that policies aiming to achieve all-to-all trading, reduce risk concentration, or lower transaction costs can be counterproductive.