Loyalty in OTC Markets

Abstract: This paper examines how relationships can mitigate frictions and improve over-the-counter (OTC) market quality. In a simple auction with bid-shading and costly bidding, a client enters a relationship with a dealer (bidder) if market frictions open space for rents that can be shared between the two loyal parties. This theory is verified with detailed quote level data from a request for quotes (RFQ) platform. The data reveal that clients maintain loyalty to their relationship dealers, even when outside dealers send more favorable prices. While corporate clients are predominantly able to receive better prices with their relationships, institutional clients rely on relationships to secure stable supply of quotes. The evidence highlights the importance of non-anonymity in OTC trading, as it facilitates the establishment of relationships and mitigates adverse effects from market friction.