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Endogenous market making and network formation

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  • Chang, Briana
  • Zhang, Shengxing

Abstract

This paper proposes a theory of intermediation in which intermediaries emerge endogenously as the choice of agents. In contrast to the previous trading models based on random matching or exogenous networks, we allow traders to explicitly choose their trading partners as well as the number of trading links in a dynamic framework. We show that traders with higher trading needs optimally choose to match with traders with lower needs for trade and they build fewer links in equilibrium. As a result, traders with the least trading need turn out to be the most connected and have the highest gross trade volume. The model therefore endogenously generates a core-periphery trading network that we often observe: a financial architecture that involves a small number of large, interconnected institutions. We use this framework to study bid-ask spreads, trading volume, asset allocation and implications on systemic risk.

Suggested Citation

  • Chang, Briana & Zhang, Shengxing, 2015. "Endogenous market making and network formation," LSE Research Online Documents on Economics 86275, London School of Economics and Political Science, LSE Library.
    • Handle: RePEc:ehl:lserod:86275
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    File URL: http://eprints.lse.ac.uk/86275/
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    More about this item

    Keywords

    Over-the-Counter Market; Trading Network; Matching; Intermediation;
    All these keywords.

    JEL classification:

    • C70 - Mathematical and Quantitative Methods - - Game Theory and Bargaining Theory - - - General
    • G1 - Financial Economics - - General Financial Markets
    • G20 - Financial Economics - - Financial Institutions and Services - - - General

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