Endogenous Liquidity and Interdealer Trading in Over-The-Counter Markets

Résumé

We develop a model of decentralized asset markets with a tiered trading structure. Dealers, who strategically supply liquidity to traders, are subject to both liquidity and adverse selection costs. Dealers can manage the liquidity cost through interdealer trading. Adverse selection, however, can complicate reallocation as dealers may be reluctant to trade with informed counterparts, as other dealers can acquire information through the accumulation of private information from market-making activities. We show that interdealer trading endogenously arises when the benefits of liquidity management outweigh adverse selection costs, and further show how market liquidity is tightly linked to interdealer liquidity. When adverse selection is too severe, interdealer trading ceases to exist, and markets become segmented. We build on this framework to study how information structure impacts market liquidity. Post-trade information disclosure, by eliminating information externalities, improves market liquidity.