The Fragility of Discretionary Liquidity Provision - Lessons from the Collapse of the Auction Rate Securities Market

60 Pages Posted: 29 Jul 2011

See all articles by Song Han

Song Han

Board of Governors of the Federal Reserve System

Li Dan

affiliation not provided to SSRN

Multiple version iconThere are 2 versions of this paper

Date Written: September 1, 2010

Abstract

We study the fragility of discretionary liquidity provision by major financial intermediaries during systemic events. The laboratory of our study is the recent collapse of the auction rate securities (ARS) market. Using a comprehensive dataset constructed from auction reports and intraday transactions data on municipal ARS, we present quantitative evidence that auction dealers acted at their own discretion as "market makers" before the market collapsed. We show that this discretionary liquidity provision greatly affected both net investor demand and auction clearing rates. Importantly, such discretionary liquidity provision is fragile. As auction dealers suffered losses from other financial markets and faced increasing inventory pressure, they stopped making markets. Moreover, the drop in support occurred suddenly, apparently triggered by the unexpected withdrawal of one major broker - dealer.

Keywords: Auction rate securities, uniform-price auctions, liquidity crisis, financial fragility, market microstructure, municipal bond pricing

JEL Classification: G01, G12, G24, D44, H74

Suggested Citation

Han, Song and Dan, Li, The Fragility of Discretionary Liquidity Provision - Lessons from the Collapse of the Auction Rate Securities Market (September 1, 2010). FEDS Working Paper No. 210-50, Available at SSRN: https://ssrn.com/abstract=1898324 or http://dx.doi.org/10.2139/ssrn.1898324

Song Han (Contact Author)

Board of Governors of the Federal Reserve System ( email )

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Washington, DC 20551
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202-736-1971 (Phone)
202-452-3891 (Fax)

Li Dan

affiliation not provided to SSRN ( email )

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