Endogenous Market Making and Network Formation
Briana Chang University of Wisconsin–Madison
Shengxing Zhang London School of Economics
April 28, 2015
Abstract
This paper develops a dynamic model of network formation in over-the-counter markets. Traders choose with whom to connect as well as whether to remain active in each period. Even though all traders have the same trading technology, we show that traders with higher trading needs optimally choose to match with traders with lower needs for trade, and also leave the market earlier. The model thus endogenously generates a core-periphery market structure, where traders who do not need to trade
turn out to be the most connected and have the highest gross trade volume. Since the role of market making is endogenous, we therefore provide an answer to why customers choose to trade with dealers instead of trading among themselves and why the financial architecture involves a small number of large, interconnected institutions. We use this framework to analyze how underlying frictions change bid-ask spreads, trading volume, and asset allocation. We further apply it to the market of interbank lending and study how the structure determines the extent of financial contagion.
Keyword: Over-the-Counter Market, Core-Periphery Trading Network, Matching, Intermediation
JEL classification: C70, G12, G21
