Abstract：
We examine a rare change in market structure. All trading in the Chinese Interbank Foreign Exchange market was originally conducted through a centralized, anonymous limit order book (LOB). In 2006, a parallel decentralized over-the-counter (OTC) market was introduced. We determine the impact of this event using intraday data. We find that: (1) the vast majority of trading migrated to the OTC market over a six-month transition, (2) the LOB price function is upward-sloping (i.e., higher transaction costs for larger trades) versus the OTC price function is downward-sloping (i.e., lower transaction costs for larger trades), and (3) the LOB market has a single price function (i.e., everyone gets the same price function) versus the OTC market has multiple price functions (i.e., larger banks get better prices). Thus, it is optimal to do small trades on the LOB and do medium and large trades in the OTC market. Next, we develop a theoretical model of parallel markets that can simultaneously explain a single upward-sloping price function on the LOB and multiple downward-sloping price functions on the OTC market. The model generates an additional empirical prediction that the critical trade size at which you switch from the LOB to the OTC is negatively related to your bargaining power. We test this prediction and find support for it.
