Illiquidity Spirals in Coupled Over-the-Counter Markets
71 Pages Posted: 7 Dec 2016 Last revised: 7 Mar 2018
Date Written: December 25, 2017
Banks provide intermediation of two economically coupled assets, each traded on an OTC market — e.g., secured debt and the underlying collateral. We model banks' decisions to provide liquidity as a game of strategic complements on two coupled trading networks: incentives to be active in one network are increasing in its neighbors' activity in both networks. When an exogenous shock renders some banks inactive, other banks follow in an illiquidity spiral across the two networks. Liquidity can be improved if one of the two OTC markets is replaced by an exchange. For a class of market structures associated with random graphs, liquidity changes discontinuously in the size of an exogenous shock, in contrast to contagion on one network.
Keywords: market liquidity, funding liquidity, over-the-counter markets
JEL Classification: G21, G23, D85
Suggested Citation: Suggested Citation