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
On many important multi-dealer platforms, customers mostly request quotes from very few dealers. I build a model of multi-dealer platforms, where dealers strategically choose to respond to or ignore a request. If the customer contacts more dealers, each dealer responds with a lower probability and offers a stochastically worse price when responding. Dealers' strategic avoidance of competition overturns the customer's benefit from potentially receiving more quotes, worsening her best-overall price. In equilibrium, the customer contacts only two dealers. Multi-dealer platforms have limited ability to promote price competition: No design of information disclosure can improve the customer's payoff above this outcome.
In a tractable model of over-the-counter markets where each investor can arbitrarily distribute her search capacity across other investors, the holdings of an asset are endogenously concentrated among a subgroup of investors. Investors who are more likely to hold the asset search among those less likely to hold it, and vice versa. When directed search is allowed in those existing random search models that endogenize intermediation, intermediation ceases to be an equilibrium outcome and instead the concentration of asset holdings arises endogenously. My model explains the persistent imbalance between banks’ funding needs, and contributes novel predictions of asset concentration across investors and asymmetric price dispersion.
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.
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.
Over-the-counter trading thrives despite opposing regulatory pressure. In our model, traders who pose a lower adverse selection risk optimally choose the OTC market, where a dealer can offer a trader-specific discount. Closing the OTC market forces some traders to exit but induces others with larger gains from trade to enter. Overall, trade volume falls, average bid-ask spread widens, and yet welfare rises if the asset is mostly OTC-traded. An easy-to-implement Pigouvian tax strictly improves welfare over closing the OTC market. We predict that the exchange's spread is wider than the OTC spread and positively correlated with its market share.
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.