DP10708 Endogenous Intermediation in Over-the-Counter Markets

Author(s): Ana Babus, Tai-Wei Hu
Publication Date: July 2015
Keyword(s): dynamic network formation, over-the-counter trading, strategic default
JEL(s): D85, G14, G21
Programme Areas: Financial Economics
Link to this Page: www.cepr.org/active/publications/discussion_papers/dp.php?dpno=10708

We provide a theory of trading through intermediaries in OTC markets. The role of intermediaries is to sustain unsecured trade. When agents trade without collateral, total surplus can increase. In our model, traders are connected through a network. Agents observe their neighbors' actions, and can trade with their counterparty in a given period through a path of intermediaries in the network. If trade is unsecured, agents can renege on their obligations. We show that trading through a network is essential to support unsecured trade, when agents infrequently meet the same counterparty in the market. However, intermediaries must receive fees to have the incentive to implement unsecured trades. While trade without collateral can be sustained in many networks, the efficiency gains are higher in a star network. The center agent in a star can receive higher fees as well. Moreover, concentrated intermediation is a stable structure, when agents incur linking costs.