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A structural model of liquidity in over‑the‑counter markets

Jamie Coen () and Patrick Coen ()
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Jamie Coen: Bank of England, Postal: Bank of England, Threadneedle Street, London, EC2R 8AH
Patrick Coen: Toulouse School of Economics

No 979, Bank of England working papers from Bank of England

Abstract: We study how firm heterogeneity determines liquidity in over‑the‑counter markets. Using a rich data set on trading in the secondary market for sterling corporate bonds, we build and estimate a flexible model of search and trading in which firms have heterogeneous search costs. We show that the 8% most active traders supply as much liquidity as the remaining 92%. Liquidity is thus vulnerable to shocks to these firms: if the 4% most active traders stop trading, liquidity falls by over 60%. Bank capital regulation reduces the willingness of these active traders to hold assets and thus reduces liquidity. However, trader search, holdings and intermediation respond endogenously to reduce the welfare costs of regulation by 30%. These costs are greater in a stress, when these margins of adjustment are constrained. The introduction of trading platforms, which homogenise the ability of traders to trade frequently, improves aggregate welfare but harms the most active traders who currently profit from supplying liquidity.

Keywords: Liquidity; over‑the‑counter markets; financial intermediation. (search for similar items in EconPapers)
JEL-codes: D83 G12 L51 (search for similar items in EconPapers)
Pages: 62 pages
Date: 2022-05-13
New Economics Papers: this item is included in nep-dge and nep-mst
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Persistent link: https://EconPapers.repec.org/RePEc:boe:boeewp:0979

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