Asymmetric Information and Inventory Concerns in Over-the-Counter Markets

We study how transparency, modeled as information about one's counterparty liquidity needs, affects the functioning of an over-the-counter market. In our model, investors hedge endowment risk by trading bilaterally in a search-and-matching environment. We construct a bargaining procedure that accommodates information asymmetry regarding investors' inventories. Both the trade size and the trade price are endogenously determined. Increased transparency improves the allocative efficiency of the market. However, it simultaneously increases inventory costs, and leads to a higher cross-sectional dispersion of transaction prices. For investors with large risk exposure, the increase of the inventory costs dominates the benefits of the market efficiency. We link the model's predictions to recent empirical findings regarding the effect of the TRACE reporting system on bond market liquidity