DP12472 Relationship Trading in OTC Markets

Author(s): Terrence Hendershott, Dan Li, Dmitry Livdan, Norman Schürhoff
Publication Date: November 2017
Keyword(s): corporate bond, Decentralization, Financial Networks, liquidity, Over-the-counter market, trading cost
JEL(s): G12, G14, G24
Programme Areas: Financial Economics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=12472

We examine the network of trading relations between insurers and dealers in the over-the-counter corporate bond market. Comprehensive regulatory data shows that many insurers use only one dealer while the largest insurers have networks of up to forty dealers. Large insurers receive better prices than small insurers. However, execution costs are a non-monotone function of the network size, increasing once the network size exceeds 20 dealers. To understand these facts we build a model of decentralized trade in which insurers trade off the benefits of repeat business against dealer competition. The model can quantitatively fit the distribution of insurers' network sizes and how prices depend on insurers' size.