Illiquidity Spirals in Coupled Over-the-Counter Markets

75 Pages Posted: 7 Dec 2016 Last revised: 6 Sep 2018

Christoph Aymanns

London School of Economics & Political Science (LSE) - London School of Economics; University of St. Gallen - School of Finance

Co-Pierre Georg

Deutsche Bundesbank; University of Cape Town (UCT)

Benjamin Golub

Harvard University

Date Written: December 25, 2017

Abstract

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

Aymanns, Christoph and Georg, Co-Pierre and Golub, Benjamin, Illiquidity Spirals in Coupled Over-the-Counter Markets (December 25, 2017). University of St.Gallen, School of Finance Research Paper No. 2018/10. 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

University of St. Gallen - School of Finance

Unterer Graben 21
St.Gallen, CH-9000
Switzerland

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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