Contagion in Dealer Networks
Dealers connect investors who want to buy or sell securities in financial markets. Over time, dealers and investors form trading networks to save time and resources. An emerging field of research investigates how networks form.
Using detailed data on trades in Government of Canada bonds, we reconstruct dealer networks and document how they respond to the release of relevant economic information. On one hand, we find that networks handle larger volumes of transactions and become more complex. On the other hand, we document more frequent and more severe contagion of settlement fails across dealer networks following these information releases. Settlement fails are unexpected delays in a buyer receiving bonds from a seller, creating counterparty risk and potential disruption to trading.
Our findings suggest a trade-off. Large, complex dealer networks effectively connect investors but are also associated with contagion and an increase in counterparty risk due to settlement fails. One way to simplify dealer networks is through a central counterparty (CCP). A CCP reduces settlement volume, making fails less likely.