DP14258 A Theory of Participation in OTC and Centralized Markets
Should regulators encourage the migration of trade from over-the-counter (OTC) to centralized
markets? To address this question, we study a model in which banks make costly decisions
to participate in an OTC market, a centralized market, or both markets at the same time.
Banks differ in their ability to take large positions, what we call their trading capacity. In
equilibrium, intermediate-capacity banks find it optimal to participate in the centralized market.
In contrast, low- and high-capacity banks find it optimal to participate in the OTC market, due
to an endogenous complementarity. Namely, low capacity banks receive worse terms of trade than
in the centralized market but better risk sharing, thanks to the intermediation services offered
by high-capacity banks. High-capacity banks receive worse risk sharing than in the centralized
market, but profit from the provision of intermediation services to low-capacity banks. While the
social optimum has qualitatively similar participation patterns, it prescribes that more customers
migrate to the centralized market, and that more dealers enter the OTC market.
