Crossborder financial contagion to Germany: How important are OTC dealers?

We examine crossborder contagion from a number of financial systems to the German financial system using the information content of CDS prices in a GARCH model. After controlling for common factors which may cause comovement in security prices, we find evidence for contagion from the US and European financial systems. Assessing contagion for dealer and non-dealer banks suggests that contagion from dealer banks is the most prominent source of contagion to the German financial system. While German non-dealer banks are affected both by European and US dealers, only US dealer banks have a contagion effect to German dealer banks.     

Relationship Trading in Over-the-Counter Markets

We examine the network of trading relationships between insurers and dealers in the over-the-counter (OTC) corporate bond market. Regulatory data show that one-third of insurers use a single dealer, whereas other insurers have large dealer networks. Execution prices are nonmonotone in network size, initially declining with more dealers but increasing once networks exceed 20 dealers. A model of decentralized trade in which insurers trade off the benefits of repeat business and faster execution quantitatively fits the distribution of insurers' network size and explains the price–network size relationship. Counterfactual analysis shows that regulations to unbundle trade and nontrade services can decrease welfare.     

Dealer Bid-Ask Quotes and Transaction Prices: An Empirical Study of Some AMEX Options

This paper, utilizing dealer's “trading book” information, presents some empirical evidence supporting the validity of a dealer pricing model. It shows that much of the transaction prices variation may be explained by the specialist's optimal determination of his bid and ask quotes. Furthermore, it demonstrates that the dealer's bid-ask spread is an important explanatory variable in the observed transaction return. Finally, it indicates that the dealer's inventory level may affect his quotes and thus the transaction prices and order arrivals. The paper provides insights into the relationship between transaction prices and equilibrium prices, which will permit more extensive use of transaction data in empirical investigations. It also provides a better understanding of optimal dealer pricing strategies, suggesting that the proposed empirical model may be used to evaluate a dealer's trading performance.     

Information Revelation in Decentralized Markets

How does information get revealed in decentralized markets? We test several hypotheses inspired by recent dealer‐network theory. To do so, we construct an empirical map of information revelation where two dealers are connected based on the synchronicity of their quote changes. The tests, based on the euro to Swiss franc spot rate (EUR/CHF) quote data including the 2015 crash, largely support theory: strongly connected (i.e., central) dealers are more informed. Connections are weaker when there is less to be learned. The crash serves to identify how a network forms when dealers are transitioned from no‐learning to learning, that is, from a fixed to a floating rate.     

So who gains from a small tick size?

We investigate the relation between price discreteness and the number of dealers in a dealer market. We present a model featuring a finite number of dealers competing in prices for supplying liquidity to a forthcoming market order. We find that a decrease in tick size benefits dealers and tends to hurt investors when the number of dealers for a stock is small. In contrast, a decrease in tick size hurts dealers and benefits investors when the number of dealers is large. This result yields several new empirical implications relating a change in tick size to entry and exit of dealers, order aggressiveness and transaction rates.     

THE DEALERS' PRICE/SIZE QUOTE AND MARKET LIQUIDITY

We model trading in a competitive securities market where informed traders and liquidity traders transact with dealers. The dealers' entire published quote is modeled: bid-ask prices and the number of shares the dealer is willing to buy/sell at these prices (i.e., size quotes). We argue that size quotes are a more informative indicator of market liquidity than the bid-ask spread's adverse-selection component. Moreover, the size quotes reveal several market characteristics that cannot be inferred from the bid-ask spread's adverse-selection component alone. The model generates a number of empirically testable predictions that clarify certain key elements of market liquidity.     

Cournot model of brokered FX trading

This paper develops a Cournot model of rival dealers placing limit orders with a broker, who in turn makes a market by acting as a liaison between dealers. The broker's limit-book lists the various prices and quantities at which dealers are willing to exchange currency vis-à-vis electronic broking. The size and volatility of the inside spread is simulated relative to dealer entry–exit and the price elasticity of linear order arrival functions. Our simulations reveal non-linear price dynamics from dealer participation in market development, with an additional rival narrowing the inside spread by 1.82% while diminishing its volatility. These findings may shed some light on the “excess volatility puzzle” raised by Killeen, Lyons and Moore (forthcoming) as to why price behavior under flexible exchange rate regimes is significantly more volatile than macro fundamentals would suggest.     

Microstructure with multiple assets: an experimental investigation into direct and indirect dealer competition

This paper uses the economic laboratory to isolate the effects of direct and indirect competition on dealer profitability. We compare these two settings: (1) three competing dealers in a single asset (direct competition) with (2) three assets with a monopoly dealer in each (indirect competition). We find that: bid–ask spreads are wider, prices are less responsive to order flow (so there is less price discovery), and per-trade dealer profits are larger in the single-asset setting. Important economic differences between these two settings include a heightened adverse selection problem in the three-asset setting and a public good nature of price discovery in the one-asset setting.     

Market structure and dealers’ quoting behavior in the foreign exchange market

This article examines how differently the same dealer quotes in the inter-dealer and customer foreign exchange markets that have different market structures. The model first predicts that customer spreads are generally wider than inter-dealer ones due to less transparency in the customer market. The model also predicts that since customers are believed to be less informed than dealers, the differential between customer and inter-dealer spreads tends to fall with the rise in order sizes. In addition, the dealer's mid-quotes are shown to be the same in the two markets. Empirical evidence based on data collected from a FX dealer supports these theoretical findings.     

Local market makers, liquidity and market quality

We examine the role of geographically proximate (local) market makers in providing liquidity and improving the quality of a dealer market. Firms with active participation of local dealers enjoy lower quoted and effective spreads, as well as more informative prices. The beneficial effects from local market makers are not confined to a few “top” local dealers and they cannot be attributed to their participation in the firm's IPO syndicate or industry specialization. Further, we find that days with aggressive bidding from local market makers relative to their non-local counterparts are associated with significant positive abnormal returns, consistent with local market makers possessing information advantages. In summary, our results suggest that the information advantages of local market makers may be a contributing factor to the reduction in the cost of trading.     

Crossing Networks and Dealer Markets: Competition and Performance

This paper studies the interaction between dealer markets and a relatively new form of exchange, passive crossing networks, where buyers and sellers trade directly with one another. We find that the crossing network is characterized by both positive ('liquidity') and negative ('crowding') externalities, and we analyze the effects of its introduction on the dealer market. Traders who use the dealer market as a 'market of last resort' can induce dealers to widen their spread and can lead to more efficient subsequent prices, but traders who only use the crossing network can provide a counterbalancing effect by reducing adverse selection and inventory holding costs.     

PRICE AND QUANTITY QUOTES ON NASDAQ: A STUDY OF DEALER QUOTATION BEHAVIOR

We show that the majority of quotes posted by NASDAQ dealers are noncompetitive and only 19.5% (18.4%) of bid (ask) quotes are at the inside. The percentage of dealer quotes that are at the inside is higher for stocks with wider spreads, fewer market makers, and more frequent trading, and lower for stocks with larger trade sizes and higher return volatility. These results support our conjecture that dealers have greater incentives to be at the inside for stocks with larger market‐making revenues and smaller costs. Dealers post large depths when their quotes are at the inside and frequently quote the minimum required depth when they are not at the inside. The latter quotation behavior leads to the negative intertemporal correlation between dealer spread and depth.     

Dealer behavior and trading systems in foreign exchange markets

We study dealer behavior in the foreign exchange spot market using detailed observations on all the transactions of four interbank dealers. There is strong support for an information effect in incoming trades. The direction of trade is most important, but we also find that the information effect increases with trade size in direct bilateral trades. All four dealers control their inventory intensively. Inventory control is not, however, manifested through a dealer's own prices in contrast to findings by Lyons (J. Financial Econ. 39(1995) 321). Furthermore, we document differences in trading styles, especially how they actually control their inventories.     

When It's Not The Only Game in Town: The Effect of Bilateral Search on the Quality of a Dealer Market

We report results from experimental asset markets with liquidity traders and an insider where we allow bilateral trade to take place, in addition to public trade with dealers. In the absence of the search alternative, dealer profits are large—unlike in models with risk-neutral, competitive dealers. However, when we allow traders to participate in the search market, dealer profits are close to zero. Dealers compete more aggressively with the alternative trading avenue than with each other. There is no evidence that price discovery is less efficient when the specialists are not the only game in town.     

Dealer behavior in the specials market for US Treasury securities

We assess dealer behavior in the specials market for US Treasury securities by comparing dealer participation in the Federal Reserve's securities loan auctions with prices in the private market. Dealer behavior is generally consistent with the law of one price and apparent violations can largely be explained by institutional differences between the private market and the Fed's program. However, for auctions that are effectively noncompetitive, dealers regularly pass up true arbitrage opportunities and frequently overpay to borrow securities. Dealers apparently do not realize that certain auctions are noncompetitive, even though the information needed to discern this fact is publicly available in advance.     

DO DEALERS INFER INFORMATION FROM ORDER FLOW?

I examine strategic behavior among dealers in the NASDAQ market and document that there is a lead quote‐setting dealer in each security and that the quotes posted by this leader are informative. Other dealers free‐ride this information by following the lead quote‐setting dealer. The lead dealer can be identified by two information signals: (1) percentage of time spent on the inside market (i.e., posting inside quotes), and (2) trade volume transacted. Dealers that free‐ride the leader's quotes quickly update their posted quotes in the same direction as the leader's quote change. My findings suggest that directing trade to the lead dealer may be more advantageous than randomly routing trade.     

Intra‐Dealer Integration

This paper examines the quotation behaviour of dealers who made markets in the same stocks on both NASDAQ and either EASDAQ or the LSE. Whereas previous studies examine international integration at the market level, we examine integration at the dealer level. In other words, do dealers within the same market‐making firm use information from their arm on the opposite side of the Atlantic in forming their own quotes? We find that while there is some evidence of integration at the market level, integration is hard to detect at the dealer level. The results are largely unaffected by differences in fungibility between our two samples.     

Risk Aversion, Transparency, and Market Performance

Using a model of market making with inventories based on Biais (1993), we find that investors obtain more favorable execution prices, and they hence invest more, when markets are fragmented. In our model, risk-averse dealers use less aggressive price strategies in more transparent markets (centralized) because quote dissemination alleviates uncertainty about the prices quoted by other dealers and, hence, reduces the need to compete aggressively for order flow. Further, we show that the move toward greater transparency (centralization) may have detrimental effects on liquidity and welfare.     

The Dynamics of Dealer Markets Under Competition

The behavior of competing dealers in securities markets is analyzed. Securities are characterized by stochastic returns and stochastic transactions. Reservation bid and ask prices of dealers are derived under alternative assumptions about the degree to which transactions are correlated across stocks at a given time and over time in a given stock. The conditions for interdealer trading are specified, and the equilibrium distribution of dealer inventories and the equilibrium market spread are derived. Implications for the structure of securities markets are examined.     

Dealer attention,the speed of quote adjustment to information,and net dealer revenue

Using trade and quote data from the NYSE, we examine the relation between dealer attention, dealer revenue, and the probability of informed trade. We find that dealer revenue net of losses to better-informed traders in NYSE stocks is positively related to the speed at which quotes adjust to full information levels. The speed of quote adjustment is faster for stocks with greater dealer attention, as measured by a stock’s relative prominence at its post and panel location on the NYSE floor. The level of dealer attention in turn is positively related to a stock’s probability of information-based trading. The results are consistent with a theoretical model we derive in which dealers trade multiple securities and must optimally allocate their limited attention to monitoring order flow to minimize losses to better-informed traders.