Working Paper Series 
               Jean-Edouard Colliard, Thierry Foucault,   Inventory management,  
                                Peter Hoffmann  dealers’ connections, and  
                                             prices in OTC markets 
           
                                               No 2529 / February 2021 
          Disclaimer: This paper should not be reported as representing the views of the European Central Bank 
          (ECB). The views expressed are those of the authors and do not necessarily reflect those of the ECB. 
                          Abstract: We propose a new model of trading in OTC markets. Dealers accumulate inven-
                        tories by trading with end-investors and trade among each other to reduce their inventory holding
                        costs. Core dealers use a more efficient trading technology than peripheral dealers, who are het-
                        erogeneously connected to core dealers and trade with each other bilaterally. Connectedness
                        affects prices and allocations if and only if the peripheral dealers’ aggregate inventory position
                        differs from zero. Price dispersion increases in the size of this position. The model generates
                        new predictions about the effects of dealers’ connectedness and dealers’ aggregate inventories on
                        prices.
                        Keywords: OTC markets, Interdealer trading, Inventory management.
                        JEL Codes: G10, G12, G19.
                        ECB Working Paper Series No 2529 / February 2021         1
                                                                                   Non‐technical Summary 
                                                  
                                                 Many important financial assets (e.g. bonds, derivatives, currencies) trade in decentralized markets, 
                                                 often referred to as “over‐the‐counter” (OTC) markets. In these markets, dealers play a key role 
                                                 because they intermediate trades between end‐investors. To do so, they accumulate substantial 
                                                                                                                                         ficant 
                                                 inventory positions. These positions are costly to hold, and are well‐known to have a signi
                                                 bearing on market liquidity. 
                                                 In order to minimize their inventory costs, dealers trade among each other in the inter‐dealer 
                                                 market. However, dealers in OTC markets are typically heterogeneous. While some are well‐
                                                 connected, others have only few trading connections, and thus may fi               cult to adjust 
                                                                                                                     nd it more diffi
                                                 their portfolio in the desired direction. 
                                                 This paper proposes a model of trading that studies the joint effects of dealers’ connectedness and 
                                                 inventory costs on prices and allocations in a decentralized OTC market. Consistent with stylized 
                                                 facts, we assume a two‐tiered structure of a de                           a more loosely 
                                                                                               nsely connected “core”, and 
                                                 connected “periphery”. While trade is frictionless in the core, peripheral dealers bargain over the 
                                                 price with a limited set of other peripheral dealers. Importantly, only some of them are “connected” 
                                                 and are able to trade with core dealers. 
                                                 The price in the core acts as a reference point for peripheral dealers because it is the price at which 
                                                 connected dealers can trade when their bilateral negotiations fail. Accordingly, changes to this price 
                                                 trickle down to the periphery, and affect the relative bargaining position of buyers and sellers.  
                                                 Given the structure of the model, there are two sources of market power among peripheral dealers. 
                                                 First, connected dealers have the option to resort to trading in the core, which improves their 
                                                 bargaining position relative to unconnected dealers. Second, a dealer’s inventory position relative to 
                                                 that of his/her competitors matters. In a market that is mainly populated by buyers, a seller wil
                                                                                                                                              l find 
                                                 it easy to get his/her trade done. In contrast, a buyer will have a hard time finding a seller, and may 
                                                 thus not be able to trade. Importantly, we show that there is price dispersion in the periphery (a sign 
                                                 of some traders exerting market power ov
                                                                                          er others) if and only if both frictions are present, i.e. if 
                                                 some dealers are unconnected and, at the same time, there is an aggregate imbalance between 
                                                 buyers and sellers. 
                                                 Our model makes precise predictions concerning how empirical researchers can measure the value 
                                                 of connectedness in OTC markets, a to                   ed considerable attention in the literature. 
                                                                                       pic that has deserv
                                            ECB Working Paper Series No 2529 / February 2021                                                          2
                           We also illustrate these insights using simulated data, and show that failing to control an interaction 
                           effect of a dealers connectedness and peripheral dealers’ aggregate inventory position can lead to 
                           incorrect inference. 
                        ECB Working Paper Series No 2529 / February 2021         3