Abstract

This paper provides a theory of dynamic formation of relationships in over-the-counter markets. I introduce a model where agents can overcome limited enforcement problems and trade risky assets without collateral if they rely on a network of relationships. A relationship between two traders enables them to condition current and future terms of trade on information they have about past transactions. Two forces drive agents.decision to form relationships. First, gathering information about counterparties is costly. Second, if agents intermediate transactions between others,they require compensation for it. A trade-o¤ between forming many relationships and trading through intermediaries arises. Although all agents are ex-ante symmetric, in equilibrium a central broker-dealer intermediates all the trade in the market.

 

Keywords: over-the-counter trading; contingent contracts; network formation;

JEL: C70; G21.