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Crises and Liquidity in Over-the-Counter Markets

45 Pages Posted: 6 Oct 2009 Last revised: 17 Mar 2010

Ricardo Lagos

New York University (NYU) - Department of Economics

Guillaume Rocheteau

Federal Reserve Bank of Cleveland; National University of Singapore (NUS)

Pierre-Olivier Weill

University of California, Los Angeles; National Bureau of Economic Research (NBER)

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Date Written: October 2, 2009

Abstract

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.

Suggested Citation

Lagos, Ricardo and Rocheteau, Guillaume and Weill, Pierre-Olivier, Crises and Liquidity in Over-the-Counter Markets (October 2, 2009). AFA 2011 Denver Meetings Paper. Available at SSRN: https://ssrn.com/abstract=1481979 or http://dx.doi.org/10.2139/ssrn.1481979

Ricardo Lagos

New York University (NYU) - Department of Economics ( email )

269 Mercer Street, 7th Floor
New York, NY 10011
United States
212-998-8937 (Phone)

Guillaume Rocheteau

Federal Reserve Bank of Cleveland ( email )

PO Box 6387
Cleveland, OH 44101-1387
United States

National University of Singapore (NUS) ( email )

Bukit Timah Road 469 G
Singapore, 117591
Singapore

Pierre-Olivier Weill (Contact Author)

University of California, Los Angeles ( email )

Box 951477
Los Angeles, CA 90095-1477
United States

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

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