Endogenous Intermediation in Security Lending Networks

We study intermediation chains in over-the-counter markets in which agents interact with counter-parties for lending and borrowing liquid assets with collateral under incomplete information. Given a financial network, liquid assets are allocated from initial lenders to final borrowers through a chain of intermediaries. In our model, agents with risky investment opportunities decide to invest the liquid asset or to be an intermediary and lend the liquid asset to other agents. Bilateral prices and lending decisions are determined by a sequence of security bid auctions. We show that the underlying network structure determines the level of competition, which in turn determines the split of expected surplus and the efficiency of asset allocation. We find that incomplete financial networks yield inefficient allocation, even though each lending in the equilibrium intermediation chain is efficient. Moreover, we show that equilibrium allocation from an initial lender to a final borrower does not necessarily proceed along the shortest path, which contrasts the general intuition that lenders and borrowers prefer to minimize the number of intermediaries