Endogenous Market Making and Network Formation

We propose a dynamic model of the over-the-counter market that jointly determines traders' connections with prices and asset flows. In an environment where ex ante homogeneous traders face uncertainty of other’s trading needs, a multilayered hierarchical market structure emerges to allow traders to better target their counterparties over time. Traders at a higher tier are committed to providing immediacy to those at a lower tier and become more central. Not only does the model rationalize the highly concentrated market and lengthy intermediation chains, it also generates new predictions for dealer centrality and markups that are consistent with the micro-level data.