Research Seminars @ Illinois

Abstract: We propose a model of over-counter-markets based on three trading methods: principal, agency, and electronic all-to-all trading (A2A). Principal, agency and A2A market sizes as well as prices and bid-ask spreads adjust in equilibrium. The model predicts that the three trading methods can coexist. A2A can remain constant while principal and agency change. Higher inventory costs shift trading from principal to agency and decrease dealers’ net positions. Bid-ask spreads decrease even though transaction costs increase. High transaction costs lead to multiple equilibria. The model shows how regulatory and technological changes affect trading choices, stability, and market indicators.