Dealer Intermediation in OTC Markets with Private Valuation

We develop a general equilibrium theory of dealer intermediation in over-the-counter (OTC) markets with private investor valuations. Trading occurs through a competitive request-for-quote (RFQ) protocol in which dealers submit price quotes without observing investor types. The model nests the standard voice trading channel. We prove the existence and uniqueness of a stationary equilibrium and characterize it through a system of functional equations. We decompose the effects of adverse selection into a scale effect, reflecting the total mass of investors on each side of the marginal type, and a composition effect, reflecting the shape of the distribution. This decomposition characterizes how equilibrium outcomes respond to changes in supply. General equilibrium feedback effects overturn standard intuitions about how dealer competition affects prices: greater competition does not uniformly improve trading terms and induces some investors to trade less. The economy with private valuations is equivalent to an economy without private information but with type-dependent trading frictions and effective bargaining power. In equilibrium, quote distributions generate bid–ask spreads, price dispersion, and strictly positive probabilities of trade failure. Our theory characterizes these objects in terms of the primitives of the economy.
(with Julien Hugonnier)