Search Frictions in Over‐the‐Counter Foreign Exchange Markets: Theory and Evidence

ABSTRACT This paper integrates theory and transaction‐level data from China's interbank over‐the‐counter (OTC) FX market to examine how search frictions affect prices, asset distributions, and welfare. We document that: (1) larger banks face lower transaction costs, decreasing with trade size; (2) easing search frictions increases dispersion in asset holdings; and (3) search frictions distort counterparty selection. These patterns follow naturally from an OTC model with heterogeneous investor search abilities and dealer fixed costs. We calibrate the model to quantify heterogeneous effects of search frictions across investors and perform counterfactual analysis to assess the impact of policies designed to decrease search frictions.