Financial Intermediation and the Cost of Trading in an Opaque Market

Municipal bonds trade in opaque, decentralized broker-dealer markets in which price information is costly to gather. Whether dealers in such a market operate competitively is an empirical issue, but a difficult one to study. Data in such markets is generally not centrally recorded. We analyze a comprehensive database of all trades between broker-dealers in municipal bonds and their customers. The data was only released to the public with a substantial lag, and thus the market was relatively opaque to the traders themselves during our sample period. We find that dealers earn lower average markups on larger trades, even though larger trades lead the dealers to bear more risk of losses. We formulate and estimate a simple structural bargaining model that allows us to estimate measures of dealer bargaining power and relate it to characteristics of the trades. The results suggest dealers exercise substantial market power. Our measures of market power decrease in trade size and increase in variables that indicate the complexity of the trade for the dealer.