Liquidity in the Cross Section of OTC Assets
67 Pages Posted: 10 Jul 2020 Last revised: 21 Sep 2021
Date Written: June 23, 2019
We develop a dynamic model of a multi-asset over-the-counter (OTC) market that operates via search and bargaining and empirically test its implications regarding liquidity in the cross section of assets. The key novelty in our model is that investors can hold and manage portfolios of OTC-traded assets. We characterize the stationary equilibrium in closed form and derive natural proxies for asset-specific measures of market liquidity including trade volume, price dispersion, and price impact. Our theoretical results uncover how cross-asset spillover effects shape the patterns of liquidity measures in equilibrium. For example, an aggravation of search frictions in one asset triggers fire sales in other assets by increasing other assets' trade volume but also making them trade with larger price impact and price dispersion. We then test empirically these key liquidity relations using data from the US corporate bond market. Overall, our empirical results indicate significant support for implications of the search-and-bargaining framework. Finally, we argue that, among the liquidity measures we analyze, price impact can serve as a good measure of welfare loss caused by OTC frictions, while other measures overstate or understate this deadweight loss.
Keywords: OTC markets, portfolio management, search and matching, bargaining, liquidity
JEL Classification: C73, C78, D53, D61, D83, E44, G11, G12
Suggested Citation: Suggested Citation