Crises and Liquidity in Over-the-Counter Markets
New York University (NYU) - Department of Economics
Federal Reserve Bank of Cleveland; National University of Singapore (NUS)
University of California, Los Angeles; National Bureau of Economic Research (NBER)
October 2, 2009
AFA 2011 Denver Meetings Paper
We study the efficiency of dealers' liquidity provision and the desirability of policy intervention in over-the-counter (OTC) markets during crises. Our theory emphasizes two key frictions in OTC markets: finding counterparties takes time, and trade is bilateral, with quantities and prices determined by bargaining. We model a crisis as a negative shock to investors' asset demands that lasts until a random recovery time. In this context, dealers can provide liquidity to outside investors by acting as counterparties in trades and by accumulating asset inventories. We find that, when frictions are severe, even well capitalized dealers may not find it optimal to accumulate inventories, given that investors choose asset positions that require small reallocations. In such circumstances, welfare can increase if the government steps in, purchases private assets on its own account, and resells them when the economy recovers.
Number of Pages in PDF File: 45
Date posted: October 6, 2009 ; Last revised: March 17, 2010
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