Trading Models and Liquidity Provision in OTC Derivatives Markets

Abstract

As part of a G20 commitment to improve transparency and mitigate systemic risk in derivatives markets, many OTC derivatives will be required to be traded on exchanges or electronic platforms by the end of 2012. It is important that liquidity on the new trading platforms is resilient, both during normal and stressed market conditions. This article discusses how liquidity is provided in different trading models and how liquidity resilience can be achieved. The article shows that liquidity provision depends on many factors, including the willingness of dealers to provide continuous prices, their ability to manage the inventory risk arising from their role as market makers, and the ability of customers to execute large or sensitive trades with minimum price impact. The article also suggests that conceptually, liquidity resilience can be achieved in a variety of trading models.