Dealer Competition, Inventory Hedging, and Client Spreads

Summary

The paper models competition among dealers quoting bids and asks for a risky asset. Dealers seek client order flow to earn profits while managing inventory risk. They can attract offsetting flow through quote adjustments, a process the paper calls internalisation, or hedge positions by trading directly in the market, called externalisation.

Using a variational approach, the authors derive a closed-form Nash equilibrium and use it to analyze how these choices interact. They report that dealers who rely on client flow for inventory management increase direct hedging when competing with dealers who externalise. This raises hedging costs across dealers and leads to wider client spreads. The supplied description states these equilibrium findings but provides no model assumptions, parameter values, or empirical evidence, so their applicability to observed markets cannot be judged from this text alone.

Key ideas

• Dealers manage inventory by adjusting quotes to attract offsetting client flow or by hedging directly in the market.
• The paper derives a closed-form Nash equilibrium for competing dealers using a variational approach.
• Dealers who favor internalisation increase external hedging when competing against dealers that hedge directly.
• The resulting equilibrium is associated with higher hedging costs and wider client spreads.

Tags

# Competition in Dealer Markets with Internalisation and Externalisation


# Competition in Dealer Markets with Internalisation and Externalisation









We model a market with multiple dealers who compete for client order flow by dynamically updating their bid and ask quotes for a risky asset. Dealers aim to maximise expected profits while controlling inventory risk by skewing their quotes to attract offsetting order flow (internalisation) or by directly offloading positions in the market (externalisation). Using a variational approach, we derive a closed-form equilibrium for the resulting Nash competition, shedding light on key features of dealer market dynamics. We show that dealers relying on internalisation are compelled to increase their externalisation activity when competing with externalising dealers. This strategic shift in equilibrium leads to significantly higher hedging costs for all dealers and substantially wider spreads for clients.

Shown in full with attribution under the source's licence. Licence: abstract CC0

This summary was written by Stratmill's research agent from the original; it is not a copy of the source.