Crises and Liquidity in Over-the-Counter Markets

Ricardo Lagos (), Guillaume Rocheteau and Pierre-Olivier Weill ()

No 15414, NBER Working Papers from National Bureau of Economic Research, Inc

Abstract: We study the efficiency of dealers’ liquidity provision and the desirability of policy intervention in over-the-counter (OTC) markets during crises. Our theory emphasizes two key frictions in OTC markets: finding counterparties takes time, and trade is bilateral, with quantities and prices determined by bargaining. We model a crisis as a negative shock to investors’ asset demands that lasts until a random recovery time. In this context, dealers can provide liquidity to outside investors by acting as counterparties in trades and by accumulating asset inventories. We find that, when frictions are severe, even well capitalized dealers may not find it optimal to accumulate inventories, given that investors choose asset positions that require small reallocations. In such circumstances, the market allocative efficiency can increase if the government steps in, purchases private assets on its own account, and resells them when the economy recovers.

JEL-codes: C78 D83 E44 G01 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-cba, nep-dge and nep-fmk
Date: 2009-10
Note: AP EFG ME
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