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Endogenous Market Making and Network Formation

date Date: April 28, 2015
date Author(s): Briana Chang, Shengxing Zhang
date Affiliation: University of Wisconsin, Madison - London School of Economics
Abstract

This paper develops a dynamic model of network formation in over-the-counter markets. Traders choose with whom to connect as well as whether to remain active in each period. Even though all traders have the same trading technology, we show that traders with higher trading needs optimally choose to match with traders with lower needs for trade, and also leave the market earlier. The model thus endogenously generates a core-periphery market structure, where traders who do not need to trade turn out to be the most connected and have the highest gross trade volume. Since the role of market making is endogenous, we therefore provide an answer to why customers choose to trade with dealers instead of trading among themselves and why the financial architecture involves a small number of large, interconnected institutions. We use this framework to analyze how underlying frictions change bid-ask spreads, trading volume, and asset allocation. We further apply it to the market of interbank lending and study how the structure determines the extent of contagion


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