Abstract: This paper provides a theory of dynamic formation of relationship in over-the-counter markets. In OTC markets, counterparties meet and set prices through a bargaining process that reflects the strategic, repeated nature of the interactions. When transactions involve counterparty risk, such as in markets for credit derivatives or bank loans, agents may find beneficial to develop a network of relationships. Evidence on borrowing and lending in interbank markets suggests indeed that banks form networks with a tiered, core-periphery structure. For instance, interactions between banks are bilateral and repeated, and only a few large institutions access the markets for liquidity, while smaller banks tend to deal with the larger ones. We identify two forces that drive the formation of such networks. On the one hand, decreasing monitoring costs encourage the formation of bilateral relationships. On the other hand, additional benefits acquired from intermediating transactions between others can explain the emergence of a few central counterparties.