The Effect of Interdealer Brokerage on the Transactional Characteristics of Dealer Markets

Abstract

Most transactions in financial assets take place either on organized exchanges or in dealer markets. The nature of the costs incurred in completing transactions differs, however, between the two types of markets. Demsetz (1968) and Tinic (1972) pointed out that transactions on organized exchanges incur commission costs to pay for the use of the specialized facilities of the exchanges and liquidity costs (in the form of bid/ask spreads) to compensate market makers for providing immediacy in purchase and sale. In most dealer markets there are no commission costs, but there is dispersion of the bid and offer quotations of competing dealers. Transactors must search among the dealers for the most favorable execution price. Unless the cost of contacting a dealer is zero the expense of search is a transaction cost of trading in a dealer market. Liquidity costs are also present in the quoted spread of each dealer. The original empirical work on the cost of transacting (Demsetz 1968; Tinic 1972) used data from organized exchanges and concentrated on liquidity costs. That work did not treat commisInterdealer trading is an important but infrequently discussed aspect of many financial markets, including the markets for United States Treasury and agency issues and prime certificates of deposit. This paper investigates the effect on price dispersion and market efficiency of introducing interdealer brokerage services in a dealer market. The result of principle interest is the role of brokers in facilitating arbitrage and reducing the dispersion of public quotations. Comparisons between bilateral and brokered dealer communication are made at various rates of trading by public investors and intensities of public search for a favorable price.

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