Liquidity Fluctuations in Over-the-Counter Markets
53 Pages Posted: 25 Feb 2020 Last revised: 15 Sep 2020
Date Written: January 1, 2020
This paper presents a model of opaque secondary markets. Investors meet over-the-counter to trade heterogeneous assets under asymmetric information. An endogenous composition effect emerges whereby high liquidity alters the quality of the pool of sellers and decreases future liquidity. With impatient investors, cyclical equilibria arise: Price and volume oscillate without any fundamental shock. With patient investors, the equilibrium is driven instead by a resale effect: Liquidity depends primarily on investors' expectations about future liquidity, and multiple steady states coexist. In each case, equilibrium liquidity is driven by the opaqueness about asset quality and trade history typical of over-the-counter markets.
Keywords: Asymmetry of Information, Liquidity, Cycles, OTC Markets, Fragility
JEL Classification: D49, D82, G28
Suggested Citation: Suggested Citation