In the era of high-frequency trading and other technological advancements on Wall Street, deal-making practices in the over-the-counter (OTC) markets seem almost quaint. In the OTC markets — home to major asset classes such as bonds, complex derivatives and real estate — traders largely still do business one-on-one in a decentralized fashion.
It couldn’t be more different from centralized markets, like the New York Stock Exchange, which are considered by many commentators and regulators as superior and more efficient with all buy-and-sell offers routed through one central body, seen simultaneously by investors and matched electronically. So why are some major asset classes still traded over-the-counter?
Two finance professors — Wharton’s Vincent Glode and Christian Opp from the University of Rochester — set out to find the answer. Their paper “Over-the-Counter versus Limit-Order Markets: The Role of Traders’ Expertise,” which is now forthcoming in the Review of Financial Studies, specifically looked at how the expertise developed by trading firms affects the relative benefits of these market structures.
Their model focuses on the fact that trading firms in OTC markets typically develop proprietary expertise in the complex securities they handle. When an asset is more complicated and information about it is not that easy to get, trading firms must spend a not-inconsequential amount of money to gain expertise.
They could hire more analysts or install a new system to track data, but they would only make that investment if it is worthwhile for them – that is, if they can make more money. Since OTC markets tend to be less competitive than centralized markets, trading firms are able to earn higher profits from expertise acquisition in these markets. In that sense, over-the-counter is a better environment for complex assets since expert traders enjoy market power.
Put another way: “OTC market yields increased rents to expertise acquisition for the subset of well-connected core traders receiving most of the order flow,” the paper said. “In contrast, stronger competition in the limit-order market reduces each individual trader’s rents from expertise, especially when the number of competing traders is large.”
There is a long-held truism that centralized markets are superior as a trading platform for all asset classes generally because there’s more liquidity and transparency. “A lot of experts are saying that everything should be traded in centralized markets,” Glode said. But “this is not what our analysis suggests.”
The OTC markets are securities marketplaces that function outside of a centralized exchange, where transactions are made through the broker-dealer network. It is home to shares of small companies that cannot or do not want to meet the costly requirements of being listed on a stock exchange. Other securities that trade over-the-counter include currencies, as well as less transparent and less liquid assets such as complex derivatives, bonds and others. The latter are assets that could trade on an exchange but typically end up being traded in over-the-counter markets; these securities are the focus of Glode and Opp’s paper.
“The OTC market structure can have positive allocative effects in the context of transactions involving securities that are primarily traded for trader-specific hedging, liquidity, and inventory motives, and where expertise helps ascertain the existence of gains from trade between market participants,” the paper said.
In contrast, the centralized market “yields advantages in transactions in which traders would primarily use expertise to seek rents by adversely selecting other market participants. These concerns, in turn, may be particularly relevant in transactions involving stocks and standardized derivatives like corporate call options,” Glode and Opp wrote.
“A lot of experts are saying that everything should be traded in centralized markets. … This is not what our analysis suggests.” –Vincent Glode
However, while the OTC markets provide more incentives for traders to develop expertise, the question of efficiency depends on the economic context, they added. If traders stand to profit too handsomely from being experts on an asset class trading over-the-counter, the result could be “socially harmful” as they will tend to corner the market and act anti-competitively, their paper said. In this case, the centralized market would be more positive overall.
Glode said the research sought to determine what market structure is “socially optimal,” meaning what’s best for society. “Our goal here is to understand how the market structure impacts firms’ incentives to acquire expertise, given that this expertise can lead to asymmetric information problems,” he said. “We want to understand the differences between the firms’ incentives to acquire superior … expertise in centralized versus decentralized markets.”
Invariably, other policy-oriented studies that compare trade efficiency across markets without accounting for the traders’ decision to acquire expertise, as well as considering the nature of that expertise, would have “relevant limitations,” they wrote. “In particular, our analysis shows that common measures, such as bid-ask spreads and transaction volume, provide little information about efficiency when expertise is endogenous and needed to assess the gains to trade.”
Moreover, when a market offers only slim gains from trading, a lot of trades are being made and traders are not motivated to gain expertise (similar to a low-margin, high-volume model), many of these trades would be money-losing due to the sheer number of transactions. “For example, if the gains to trade were symmetrically distributed with a mean close to zero, then approximately 50% of transactions would actually destroy surplus and should be avoided,” according to the paper.
Compare that to a market structure that encourages traders to gain expertise, which would have higher ask prices and much fewer trades (high-margin, low-volume model). Profits would be higher because traders have a greater capability of avoiding money-losing trades. “From a policy perspective, these insights are potentially of first-order relevance when drawing conclusions based on existing empirical evidence across markets.”
“These insights are potentially of first-order relevance when drawing conclusions based on existing empirical evidence across markets.” –Vincent Glode and Christian Opp
“In particular, our model’s predictions for the OTC market are fully consistent with empirical studies documenting higher spreads, lower volume, and greater rents for a small set of dealers in these markets,” they continued. “Yet our analysis highlights that, in classes of transactions where expertise is needed to inform agents about the presence of gains from trade, these empirical observations do not lend themselves to the conclusion that limit-order (centralized) markets would yield higher levels of allocative efficiency.”
Finally, as the paper shows, regulators should not conclude that all assets should trade in centralized markets because these markets are more liquid and transparent than decentralized markets. “When expertise yields information that helps agents determine whether a transaction generates positive economic surplus, heightened incentives for expertise acquisition can be essential for allocative efficiency,” according to the authors.
“In contrast, when expertise merely provides an information advantage about an asset’s value, rather than about the value added from transacting, it introduces adverse selection and impedes the efficiency of trade,” they further pointed out. “These results have potentially important implications for ongoing debates about regulatory reforms that aim to curtail OTC trading in favor of trading in centralized markets.”