Endogenous Market Making and Network Formation∗

This paper proposes a theory of intermediation, in which intermediaries emerge endogenously as the choice of agents. In contrast to the previous trading models based on random matching or exogenous networks, we allow traders to explicitly choose their trading partners as well as the number of trading link in a dynamic framework. Even though all traders have the same trading technology, we show that traders with higher trading needs optimally choose to match with traders with lower needs for trade, and build less links in equilibrium. As a result, traders with lower exposures turn out to be the most connected and have the highest gross trade volume. The model therefore endogenously generates a core-periphery trading network that we often observed: a financial architecture that involves a small number of large, interconnected institutions. We use this framework to study bid-ask spreads, trading volume, and asset allocation. We further analyze the financial interdependence as well as the propagation of shocks within the system by applying the model to unsecured lending markets