Essays on Over-the-Counter Markets

This dissertation comprises two essays on over-the-counter (OTC) markets, covering both the primary and secondary markets for municipal bonds.

In the first chapter, I explore a novel channel through which exchange-traded funds (ETFs) improve pre-trade price transparency and thereby retail investors' bargaining power in OTC markets. ETFs are required to daily disclose their full holdings, often along with their constituents’ end-of-day prices, which are good timely references for investors to negotiate with broker-dealers, particularly when the securities have not traded recently. I find that ETF-held bonds have significantly lower retail markups than those of bonds not held by ETFs. This effect cannot be explained by selection or ETFs' own trading activity but is driven by the daily disclosures by ETFs holding the bonds. During 2010--2021, retail investors saved over $200 million when trading ETF-held bonds. There is also a spillover effect to the primary market---when municipalities have outstanding ETF-held bonds, their new issues have lower yields and smaller price dispersion.

In the second chapter, I both theoretically and empirically document a non-monotonic relation between local municipal bond mutual funds, or informed investors, and underpricing in the municipal bond market. Empirically speaking, offering yields are higher in states that have open-end municipal bond funds, and with larger aggregate fund size. However, holding local fund size constant, yields decrease in the number of funds. Such relations hold when local funds' primary market participation is instrumented with the similarities in characteristics of new issues and existing bonds in their portfolios. I further confirm my empirical findings with a security underpricing model that incorporates the imperfect signals available to informed investors. Despite facing higher borrowing costs, issuers benefit from local funds' certification resulting in both institutional and retail investors' higher demand in the primary market.