True Cost of Immediacy

Abstract

Markets can give a false impression of their liquidity and stability if failed attempts to trade are not accounted for. We quantify this bias by estimating the distribution of investors' reserve prices using data on auctions (bids wanted in competition; BWICs) from the collateralized loan obligation (CLO) market. We show that the true cost of immediacy (TCI) is substantially higher than the observed cost for successful BWICs because trade failures are frequent and failure costs that constitute lost gains from trade are large and correlated with failure rates. The average observed cost across credit quality is 0.04-0.12% while TCI is 0.31-3.79%. TCI is higher in lowerrated CLOs and stressful market conditions when failure rates exceed 50% and failure costs exceed 10%, suggesting substantial market fragility. For these tranches TCI is almost double gains from trade and TCI for sellers with low reserve price is more than 50% higher than the median.

Keywords: Liquidity, bids-wanted-in-competition, collateralized loan obligations, securities auctions, over-the-counter market structure

JEL Classification: G12, G14, G24