Über die Autorin bzw. den Autor

Darrell Duffie is the Dean Witter Distinguished Professor of Finance at Stanford University's Graduate School of Business. His books include "How Big Banks Fail and What to Do about It" and "Dynamic Asset Pricing Theory" (both Princeton).

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"Over-the-counter markets concern a large set of financial assets and received significant attention during the recent financial crisis. Darrell Duffie has been a key contributor to a promising new area of research that seeks to understand the behavior of these markets. His comprehensive, rigorous book will be very useful to all researchers interested in this important subject."--Dimitri Vayanos, London School of Economics and Political Science

"Dark Markets describes and models over-the-counter markets, with an emphasis on 'doing it right.' People apply the law of large numbers all the time, even when it is inappropriate. This book tells you when it is appropriate. Darrell Duffie is a giant in the field."--Ed Nosal, Federal Reserve Bank of Chicago

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"Over-the-counter markets concern a large set of financial assets and received significant attention during the recent financial crisis. Darrell Duffie has been a key contributor to a promising new area of research that seeks to understand the behavior of these markets. His comprehensive, rigorous book will be very useful to all researchers interested in this important subject."--Dimitri Vayanos, London School of Economics and Political Science

"Dark Markets describes and models over-the-counter markets, with an emphasis on 'doing it right.' People apply the law of large numbers all the time, even when it is inappropriate. This book tells you when it is appropriate. Darrell Duffie is a giant in the field."--Ed Nosal, Federal Reserve Bank of Chicago

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Dark Markets

PRINCETON UNIVERSITY PRESS

Contents

List of Tables...............................................ixList of Figures..............................................xiPreface......................................................xiii1 Over-the-Counter Markets...................................12 The Case of Federal Funds Lending..........................133 Search for Counterparties..................................274 A Simple OTC Pricing Model.................................425 Information Percolation in OTC Markets.....................63A Foundations for Random Matching............................79B Counting Processes.........................................84Bibliography.................................................87Index........................................................93

Chapter One

An over-the-counter (OTC) market does not use a centralized trading mechanism, such as an auction, specialist, or limit-order book, to aggregate bids and offers and to allocate trades. instead, buyers and sellers negotiate terms privately, often in ignorance of the prices currently available from other potential counterparties and with limited knowledge of trades recently negotiated elsewhere in the market. OTC markets are thus said to be relatively opaque; investors are somewhat in the dark about the most attractive available terms and about whom to contact for attractive terms. Prices and allocations in OTC markets are to varying extents influenced by opaqueness and by the role of intermediating brokers and dealers. this chapter outlines some of the key institutional features of OTC markets that influence the formation of prices and allocations. Many details are omitted.

Some of the key research and policy issues regarding OTC markets include: (i) criteria that determine whether a financial product trades in an OTC market or on an exchange, (ii) the manner in which the price negotiated on a particular trade reflects the relative degrees of connectedness of the buyer and seller with the rest of the market, (iii) the formation and behavior of dealer franchises and oligopolies as well as interdealer brokers, (iv) the influence of market structure on the cross-sectional dispersion of prices negotiated at a particular time and on the time signature of price reactions to supply or information shocks, (v) the evolution over time of the distribution across investors of information learned from private trade negotiations, (vi) the effect of pre-trade and post-trade price transparency on market behavior, (vii) the impact of counterparty credit risk on pricing and financial stability, and (vii) the equilibrium strategies chosen by investors regarding their search for counterparties. some of these issues form the main subject matter of this book. others are left open for future research.

1.1 BILATERAL NEGOTIATION OF TERMS

Assets traded over the counter include most types of government and corporate bonds, asset-backed securities, securities lending and repurchase agreements, a wide range of derivatives, real estate, currencies, bulk commodities, shipping rights, and large blocks of equities. In most of these markets, trade is intermediated by dealers. Although the term "dealer" carries some legal distinctions in certain markets, the main difference between a dealer and other market participants is that, by convention, an OTC dealer is usually expected to make "two-way markets," in the following manner.

An OTC trade negotiation is typically initiated when an investor contacts a dealer and asks for terms of trade. communication could be by phone, by e-mail, by screen-based query systems, or through a broker. A dealer making two-sided markets typically provides a take-it-or-leave-it pair of prices, a bid and an offer, to a customer. The customer may accept by immediately hitting the bid or lifting the offer. Dealer bids and offers are understood to be good for quantities up to an agreed conventional amount in standardized products. After agreeing on a price, a customer and dealer may further negotiate the quantity to be exchanged at the agreed price. Occasionally, if a customer declines to trade at the dealer's quotes, the dealer may offer a price concession rather than lose the opportunity to trade. In this case, the dealer is making a tradeoff between the value of maintaining a reputation for standing firm on its original quotes and the profit opportunity of the current trade. A dealer trades for its own account and assumes the risk that it cannot offset a position at a profitable price.

An OTC bargaining game can be complex because of private information and the potentially rich sets of outside options of the respective counterparties. The counterparties may have different information regarding the common-value aspects of the asset (for example, the probability distribution of the asset's future cash flows), current market conditions, and their individual motives for trade. The counterparties may also be distinguished from each other with respect to their alternative trading opportunities, which depend on the manner and extent of their participation in the market. For example, a dealer frequently negotiates trades and receives information, while the customer of a dealer usually has more limited opportunities to trade and thus relatively less information about recent transactions. Their different degrees of access to the market are in this case relatively common knowledge and tend to convey a negotiating advantage to the dealer. Beyond having more information than many of its customers, a dealer usually has less difficulty in adjusting inventories. The negotiating advantage to a dealer may be increased when there are relatively few dealers with whom to negotiate. For example, as modeled by Zhu (2010), if an investor returns to a dealer from whom quotes have already been obtained, the dealer infers that the investor has had difficulty obtaining better terms from other dealers and is likely to offer even less attractive quotes to the investor.

Chapter 4 presents a simple model of the determination of prices in an OTC market with symmetric information. in this setting, prices reflect the fundamental values of the asset to the respective investors as well as the outside options of the respective counterparties to search for new trading partners. chapter 5 focuses on the dynamics of asymmetric information across the population that is generated by OTC trading.

Some OTC markets have special intermediaries known as brokers that assist in negotiations between buyers and sellers, conveying the terms of one investor to another, usually without revealing the identities of the counterparties to each other. As opposed to dealers, a broker need not trade on its own account. Some brokers specialize in intermediating between dealers. a broker's customers rely on the broker for anonymity and for the broker's information regarding the most likely interested counterparties. negotiation in OTC markets through brokers is often based on a "workup" protocol. Once the initial price and quantity are agreed on, one party can offer to expand the quantity of the trade. Further expansions can continue until at least one of the parties declines, although other parties in contact with the broker can then "enter" the trade at the same price, until no further trading interest is expressed at the original price, closing the trade. Huang, Cai, and Wang (2002), Boni and Leach (2004), and Pancs (2010) provide further description and analysis of the workup procedure and expandable-order markets.

Over the past decade, the majority of interdealer and customer-to-dealer brokerage has moved to electronic platforms such as espeed, Brokertec, Bloomberg, Marketaxess, Mts, and tradeWeb. Electronic trading platforms are likely to become more popular in OTC derivatives markets because of language in the U.S. Dodd-Frank act of 2010 that mandates the trade of standardized OTC derivative products on a "swap execution facility" (SEF) that allows some degree of competition for trades among multiple market participants. As of this writing, the securities and exchange comission (SEC) and the commodity Futures trading commission (CFTC) have yet to define what will constitute an acceptable norm for SEFs. Once that is completed, perhaps in late 2011, the design of SEFs and the migration of trade in standardized OTC derivatives to SEFs will occur over time.

1.2 OTC TRANSPARENCY

In some dealer-based OTC markets, especially those with active brokers, a selection of recently quoted or negotiated prices is revealed to a wide range of market participants, often through electronic media such as Reuters, Bloomberg, or MarkitPartners. For other OTC markets, such as those for U.S. corporate and municipal bonds, regulators have mandated post-trade price transparency through the publication of an almost complete record of transactions shortly after they occur. In the united states, post-trade price reporting in many bond markets is done through the trade reporting and compliance engine (TRACE), which provides the price for each transaction within minutes of the trade. If the trade size is less than a stipulated threshold, TRACE reports the traded quantity. Otherwise, TRACE reports that the quantity was above the threshold. The size of extremely large trades is not publicly disclosed so that liquidity providers such as dealers have the chance to reduce inventory imbalances stemming from large trades with less concern that the size of a trade or their reservation price will be used to the bargaining advantage of their next counterparties.

In some active OTC derivatives markets, such as the market for credit default swaps, clients of dealers can request "dealer runs," which are essentially lists of dealers' prospective bid and offer prices on a menu of potential trades. Dealers risk a loss of reputation if they frequently decline the opportunity to trade near these indicative prices when contacted soon after providing quotes for a dealer run.

Despite these sources of information, price transparency is typically lower for OTC markets than for exchange-based markets, such as those based on electronic communication networks (ECNs), in which there is essentially complete and immediate transactions reporting as well as pre-trade transparency that includes at least the best executable bid and offer. The complete contents of a typical ECN limit-order book are not normally disclosed. Some limit-order-book markets allow "icebergs," components of a limit order that have undisclosed quantities. Those submitting icebergs may wish to reduce inference by market participants that could worsen the order submitter's ultimate average execution price.

Increasingly, investors can allocate orders to off-exchange "dark pools," where they are crossed at prices that were recently executed on exchanges. individual trades in dark pools are not normally disclosed. There has been some concern that the increasing fraction of equity trades sent to dark pools may lead to less competition for priced (on-exchange) trades and therefore less market liquidity and price discovery. Zhu (2011) shows theoretical support, however, for a tendency of dark pools to be relatively heavily populated by less informed traders. Under conditions, the presence of dark pools leads to a higher concentration of more highly informed traders at "lit" exchanges, which can actually improve price discovery.

The profits of a dealer depend on the volume of trade it handles and on the average difference between bid and ask prices, which in turn depends on the degree to which the dealer's customers are likely to have information relevant to prices available elsewhere in the market. Dealers therefore prefer at least some degree of market opaqueness. As pre-trade and post-trade price transparency increases, dealers have incentives to narrow their bid-offer spreads in order to compete for trading opportunities. If price transparency is too great, however, some dealers may lose the incentive to intermediate, given their fixed costs and the risk of adverse selection by informed customers. Unless the potential demand to trade a financial product is sufficient to justify exchange trading, a sufficiently large increase in OTC market transparency could therefore potentially reduce trading opportunities for investors.

Empirical anlyses of the implications of post- trade price transparency in bond markets, through trace, include those of Bessembinder and Maxwell (2008), Edwards, Harris and Piwowar (2007), Goldstein, Hotchkiss, and Sirri (2007), Green, Hollifield, and Schürhoff (2007a, 2007b), and green, Li Schürhoff (2011). at this point, the empirical evidence does not generally support prior concerns expressed by dealers that the introduction of trace would reduce market liquidity.

The U.S. Dodd-Frank act of 2010 regulates the transparency and stability of OTC derivatives markets in the united states. The European commission plans to follow with its own new regulations. In addition to the impact on market transparency of mandated trade of standardized derivatives on swap execution facilities, the transparency requirements of the Dodd-Frank act are of several major types: (i) the disclosure to regulators of all trade information through data repositories, (ii) the public disclosure of some aggregate information on trading volumes, and (iii) the public disclosure of transaction prices of standardized derivatives. the system for transaction price disclosure could be modeled on TRACE.

1.3 WHY TRADE OVER THE COUNTER?

Some of the lack of transparency of OTC markets is inherent in the nature of the underlying products. For example, a wide range of collateralized debt obligations and other structured credit products are thinly traded and have complex contractual features that could be analyzed well by only a narrow range of specialized investors. Even if such instruments were traded on an exchange, liquidity and transparency would be lacking. In any case, many such instruments could rarely achieve the volume and breadth of participation that would justify exchange- based trade. These are natural candidates for OTC trading, where customization of financial products to the needs of investors is more easily arranged. On request, an investment bank can offer A customer a new financial instrument for which there is no active market. in effect, an OTC market for that instrument is thereby created and may over time become established on the basis of additional trading. Eventually, if the product becomes sufficiently standardized and popular, its trade may migrate to an exchange.

Tufano (1989) describes the motivation of banks to innovate financial products. The introducer of a new financial product benefits in the short run from a temporary monopoly in the distribution of the product, through its command of the necessary technical and legal knowledge. Over time, a product may become sufficiently popular to encourage entry by other dealers. At this point, the original dealer's profit margins are likely to decline, although it may have a somewhat persistent advantage in terms of volume handled.

Some financial products with high volumes of trade that are relatively standard, for example, recently issued U.S. government bonds and certain liquid OTC derivatives (such as simple interest rate swaps and credit derivative index products), seem like natural candidates for exchange-based trade but are normally traded over the counter. At this point, we lack convincing theories that explain why such simple and heavily traded instruments are traded over the counter. Dealers have a vested interest in maintaining trade in OTC markets, where the profitability of intermediation is enhanced by market opaqueness. Once liquidity is established in OTC markets, it may be difficult for exchanges to compete for a critical mass of order flow, as investors are naturally drawn to the most liquid available market.

The prevalence of OTC trading for some standard financial products may be based in part on the granularity of trade sizes. Transactions of on-the-run government bonds, for instance, are often in quantities that are a substantial fraction of the total issuance size or daily volume of trade. A large quantity might be bought or sold at a more favorable price through private negotiation with a specialized OTC counterparty than by exposing the new demand or supply to a limit-order-book market populated by diversely motivated order submitters, where more severe price concessions may be required to digest a large position. For example, large block trades of equities are often executed in the private "upstairs" market of the New York stock exchange. Her Majesty's Treasury reports an estimate by CREST, the United Kingdom's securities settlement system, that of the cash equity transactions placed into its system, OTC executions account for approximately 4% of the share volume and 14% of the market value of trades.

(Continues...)

Excerpted from Dark Marketsby Darrell Duffie Copyright © 2012 by Princeton University Press. Excerpted by permission of PRINCETON UNIVERSITY PRESS. All rights reserved. No part of this excerpt may be reproduced or reprinted without permission in writing from the publisher.
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