The Risk Sharing Benefi t versus the Collateral Cost: The Formation of the Inter-Dealer Network in Over-the-Counter Trading

The decentralized over-the-counter (OTC) market generates a trading network among dealers. We model the driver behind the formation of this inter-dealer network as the need for dealers to share risk. The trade-o¤ between the benefit of risk-sharing and the funding cost of collateral determines the shape of the inter-dealer network. In equilibrium, dealers’ markups and trading volumes increase with the number of links they have to other dealers, whereas dealers’inventory risks decrease as they form links. In addition, when capacity of providing liquidity differentiates dealers, the network formed exhibits the empirically observed core-periphery structure: dealers with large capacity comprise the core of the network, connecting them to all other dealers, while dealers who have small capacity operate at the periphery. The model matches recent empirical findings on the negative relationship between order sizes and markups. More importantly, we show that there may be structural breaks in this negative relationship as variations in order sizes may alter the inter-dealer network. These results suggest that empirical studies on OTC markets should control for the stability of an inter-dealer network to avoid model misspeci cation.