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Illiquidity Spirals in Coupled Over-the-Counter Markets

71 Pages Posted: 7 Dec 2016 Last revised: 26 Dec 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: December 25, 2017

Abstract

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

Aymanns, Christoph and Georg, Co-Pierre and Golub, Benjamin, Illiquidity Spirals in Coupled Over-the-Counter Markets (December 25, 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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