Dealer Networks

Abstract

Dealers mitigate search frictions in over-the-counter markets by forming trading networks. The MSRB Transaction Reporting System audit trail shows the dealership network in municipal bonds is sparse and has a tiered core-periphery structure. Bonds are intermediated in chains in which central dealers act as hubs. Order execution quality varies across dealers depending on their centrality. Consistent with lower search frictions, central dealers place bonds more readily with investors than peripheral dealers. Investors face a tradeoff between trading costs and liquidity. Central dealers charge larger markups to investors than peripheral dealers but also offer higher liquidity, including pre-arranging fewer trades, keeping bonds longer, and holding larger and more volatile inventories. Investors with high liquidity needs trade with central dealers, in less liquid bonds and when market liquidity is low. Central dealers thus serve as liquidity providers of last resort.