Illiquidity Spirals in Coupled Over-the-Counter Markets

50 Pages Posted: 7 Dec 2016 Last revised: 8 Apr 2017

Christoph Aymanns

London School of Economics & Political Science (LSE) - London School of Economics

Co-Pierre Georg

Deutsche Bundesbank; University of Cape Town (UCT)

Benjamin Golub

Harvard University

Date Written: April 7, 2017

Abstract

In many financial markets, two distinct over-the-counter (OTC) trading networks are coupled through the decisions of traders who want to be active in both networks or neither. We provide a novel explanation for the fragility of such markets in terms of this coupling. Our main application considers an OTC repo market coupled with the market for its collateral. Traders' decisions of whether to provide funding and market liquidity are modeled as the equilibrium outcome of a static game involving two directed networks. We characterize the general structure of an illiquidity spiral in such a system: following an exogenous shock, a sequence of withdrawals occurs, corresponding to a contagion across the two networks. Furthermore, for a class of market structures associated with random graphs, liquidity changes discontinuously in the extent of an exogenous shock, in contrast to standard models of network contagion.

Keywords: market liquidity, funding liquidity, over-the-counter markets

JEL Classification: G21, G23, D85

Suggested Citation

Aymanns, Christoph and Georg, Co-Pierre and Golub, Benjamin, Illiquidity Spirals in Coupled Over-the-Counter Markets (April 7, 2017). Available at SSRN: https://ssrn.com/abstract=2881814 or http://dx.doi.org/10.2139/ssrn.2881814

Christoph Aymanns (Contact Author)

London School of Economics & Political Science (LSE) - London School of Economics ( email )

United Kingdom

Co-Pierre Georg

Deutsche Bundesbank ( email )

Wilhelm-Epstein-Str. 14
Frankfurt/Main, 60431
Germany

University of Cape Town (UCT) ( email )

Private Bag X3
Rondebosch, 7701
South Africa

Benjamin Golub

Harvard University ( email )

Littauer Center, Dept of Economics
1805 Cambridge Street
Cambridge, MA 02138
United States

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