Issuers, Underwriter Syndicates, and Aftermarket Transparency∗

I model strategic interaction between issuers, underwriters, retail investors, and institutional investors when the secondary market has limited price transparency. Search costs for retail investors lead to price dispersion in the secondary market, while the price for institutional investors is infinitely elastic. Because retail distribution capacity is assumed to be limited for each underwriterdealer, Bertrand competition breaks down in the primary market, and new issues are underpriced in equilibrium. Syndicates emerge, in which underwriters bid symmetrically, and allocate quantities internally to efficiently utilize retail distribution capacity. Underwriters and dealers appear to compete vigorously for new security issues, and yet also appear to earn high profits in this business. What value are they generating that warrants high compensation? Are there obstacles that keep this value from flowing through to security issuers, despite apparently fierce competition in the market for these financial services? The model in this paper combines three elements: a lack of price transparency in the secondary market, limited retail distribution capacity, and Bertrand competition in the primary market. Dealer-underwriters bid for new securities as Bertrand competitors. They then sell these securities in a secondary market with limited price transparency. Retail investors face costs of gathering price information, while institutional investors, who are frequent, repeat customers, do not. This leads to price dispersion in the secondary market, where some retail customers get attractive terms and others do not. The rents that accrue to broker-dealers, who can sell to retail customers, are limited by their distribution capacity. This, in turn, limits their incentives to bid aggressively in the primary market. In equilibrium, they share the new issues through arrangements that resemble underwriter syndicates. New issues are underpriced relative to average subsequent transactions prices. The results illustrate how non-competitive outcomes in the secondary market can lead to breakdowns in competition in the primary market, and why issuers may have little to gain from improved price transparency. While more transparency limits the rents dealers can extract from retail investors in the secondary market, the lost rents are not absorbed by issuers. Mechanisms that divide rents between issuers and underwriters, whether through explicit price concessions by underwriters, or through golf games and closing dinners, will lead issuers to oppose institutional reforms aimed at improved price transparency. The benefits of transparent pricing in securities markets, and the costs of mandating transparency, have become central concerns for researchers, regulators and investors in the U.S. and abroad. Many important securities trade over the counter. In some of these markets, such as those for currency or credit swaps, trading is dominated by professional, sophisticated intermediaries, and the benefits of mandated price transparency would seem to be minimal. In other cases, such as the markets for municipal or corporate bonds, there are significant retail holdings of the securities, or at least their might be if terms of trade for these investors were not so punitive.