Assistant Professor of Finance, The Wharton School, University of Pennsylvania
Member, Finance Theory Group
Research Interest: Over-the-counter financial markets, market structure, market design
Email: wangchj (AT) wharton.upenn.edu
In a model of multi-dealer platforms where dealers endogenously choose whether to respond to a client’s request for quote, the client chooses to contact only two dealers in equilibrium. Contacting more dealers would lower each dealer’s response probability, which in turn causes each responding dealer to offer a stochastically worse price. These two negative effects on dealer behavior more than offset the benefit of contacting more dealers for quotes. No alternative platform design can improve the client's expected payoff. In this sense, multi-dealer platforms are limited in their ability to reduce dealer market power and promote price competition.
Contrary to the prediction of the classic adverse selection theory, more informed traders could receive better pricing relative to less informed traders in over-the-counter financial markets. Dealers actively chase informed orders to better position their future quotes and avoid winner's curse in subsequent trades. On a multi-dealer platform, dealers' incentive of information chasing exactly offsets their fear of adverse selection. In a more general setting, information chasing can dominate adverse selection when dealers face differentially informed speculators, while adverse selection dominates when dealers face differentially informed trades from a given speculator. These two seemingly contrasting predictions are supported by empirical evidence from the UK government bond market.
We show that larger trades incur lower trading costs in government bond markets (“size discount”), but costs increase in trade size after controlling for clients’ identities (“size penalty”). The size discount is driven by the cross-client variation of larger traders obtaining better prices, consistent with theories of trading with imperfect competition. The size penalty, driven by within-client variation, is larger for corporate bonds and during major macroeconomic surprises as well as during COVID-19. These differences are larger among more sophisticated clients, consistent with theories of asymmetric information. We propose a trading model with bilateral bargaining and adverse selection to rationalize the co-existence of the size penalty and discount.
Over-the-counter trading dominates in many highly liquid assets. We provide an explanation: OTC trading is privately optimal for traders who are likely uninformed. Traders choose between an exchange and a dealer, who cream-skims those likely uninformed. Closing the OTC market directly causes certain traders to exit, while inducing some others to enter by improving prices on the exchange. Overall, closing the OTC market raises welfare for assets whose trades are mostly over the counter, despite reducing aggregate trade volume and widening average bid-ask spread. We predict and document a positive correlation between the market share of exchanges and their quoted spreads.
Core-periphery trading networks arise endogenously in over-the-counter markets as an equilibrium balance between trade competition and inventory efficiency. A small number of firms emerge as core dealers to intermediate trades among a large number of peripheral firms. The equilibrium number of dealers depends on two countervailing forces: (i) competition among dealers in their pricing of immediacy to peripheral firms, and (ii) the benefit of concentrated intermediation in balancing dealer inventory through dealers’ ability to quickly net purchases against sales. For an asset with a lower frequency of trade demand, intermediation is concentrated among fewer dealers, and interdealer trades account for a greater fraction of total trade volume. These two predictions are strongly supported by evidence from the Bund and U.S. corporate bond markets. From a welfare viewpoint, I show that there are too few dealers for assets with frequent trade demands, and too many for assets with infrequent trade demands.
We model bargaining in over-the-counter network markets over the terms and prices of contracts. Of concern is whether bilateral non-cooperative bargaining is sufficient to achieve efficiency in this multilateral setting. For example, will market participants assign insolvency-based seniority in a socially efficient manner, or should bankruptcy laws override contractual terms with an automatic stay? We provide conditions under which bilateral bargaining over contingent contracts is efficient for a network of market participants. Examples include seniority assignment, close-out netting and collateral rights, secured debt liens, and leverage-based covenants. Given the ability to use covenants and other contingent contract terms, central market participants efficiently internalize the costs and benefits of their counterparties through the pricing of contracts. We provide counterexamples to efficiency for less contingent forms of bargaining coordination.