Illiquidity Spirals in Coupled Over-the-Counter Markets
75 Pages Posted: 7 Dec 2016 Last revised: 6 Sep 2018
Date Written: December 25, 2017
We model intermediaries trading economically coupled assets, each asset in its own over-the-counter market--e.g., secured debt and the underlying collateral. Incentives to provide liquidity in one market are increasing in counterparties' activity in both markets. The intermediaries' activity is thus the outcome of a game of strategic complements on two coupled trading networks. We model a crisis as an exogenous change to network structure, as well as the exogenous exit of some intermediaries. This causes an illiquidity spiral across the two networks. We find that in coupled networks, in contrast to uncoupled ones, illiquidity spirals can be so severe that liquidity vanishes discontinuously as we vary the shock. Liquidity can be improved if one of the two OTC markets is replaced by an exchange, or if the two OTC markets have more links in common.
Keywords: market liquidity, funding liquidity, over-the-counter markets
JEL Classification: G21, G23, D85
Suggested Citation: Suggested Citation