|Research Paper 130|
Financial Intermediation and the Costs of Trading in an Opaque Market
C. GREEN, Tepper School of Business, Carnegie Mellon University
Burton HOLLIFIELD, Tepper
School of Business, Carnegie Mellon University
Norman SCHÜRHOFF, HEC, University of Lausanne
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bonds trade in opaque, decentralized broker-dealer markets in which price information is costly to gather.
Whether dealers in such a market operate competitively is an empirical issue, but a difficult one to
study. Data in such markets is generally not centrally recorded. We analyze a comprehensive database
of all trades between broker-dealers in municipal bonds and their customers. The data is only released
to the public with a substantial lag, and thus the market was relatively opaque to the traders themselves
during our sample period. We find that dealers earn lower average markups on larger trades, even
though larger trades lead the dealers to bear more risk of losses. We formulate and estimate a simple
structural bargaining model that allows us to estimate measures of dealer bargaining power and relate
it to characteristics of the trades. The results suggest dealers exercise substantial market power.
Our measures of market power decrease in trade size and increase in variables that indicate the complexity
of the trade for the dealer.