A Principal-Agent Model of Trading Under Market Impact -Crossing networks interacting with dealer markets-

TL;DR

This paper models how crossing networks impact dealer markets using a principal-agent framework, showing that such networks can increase dealer servicing and reduce spreads under certain conditions.

Contribution

It introduces a principal-agent model analyzing the interaction between dealer markets and crossing networks, highlighting conditions for equilibrium and spread reduction.

Findings

Crossing networks lead to more types being serviced by dealers.

Presence of crossing networks can reduce the dealer market spread.

Equilibrium exists under certain pricing and network conditions.

Abstract

We use a principal-agent model to analyze the structure of a book-driven dealer market when the dealer faces competition from a crossing network or dark pool. The agents are privately informed about their types (e.g. their portfolios), which is something that the dealer must take into account when engaging his counterparties. Instead of trading with the dealer, the agents may chose to trade in a crossing network. We show that the presence of such a network results in more types being serviced by the dealer and that, under certain conditions and due to reduced adverse selection effects, the book's spread shrinks. We allow for the pricing on the dealer market to determine the structure of the crossing network and show that the same conditions that lead to a reduction of the spread imply the existence of an equilibrium book/crossing network pair.