Ana Babus, Cecilia Parlatore - January 24, 2018
We study the determinants of asset market fragmentation. We develop a model of market formation with strategic investors that have heterogeneous valuations for an asset. Investors choose a dealer with whom to trade considering their price impact and the liquidity provided by the dealer. Fragmented markets are supported in equilibrium when investors' valuations are sufficiently correlated. In this case, liquidity provision is scarce and investors are more willing to accept a higher price impact. The maximum degree of market fragmentation is determined by dealer entry, and increases as investors' valuations are more correlated. Dealers can benefit from fragmentation, but investors are always better off in centralized markets.