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Liquidity misallocation in an over-the-counter market

Shengxing Zhang

LSE Research Online Documents on Economics from London School of Economics and Political Science, LSE Library

Abstract: To understand the illiquidity of the over-the-counter market when dealers and traders are in long-term relationships, I develop a framework to study the endogenous liquidity distortions resulting from the profit-maximizing, screening behavior of dealers. The dealer offers the trading mechanism contingent on the aggregate history of his customers summarized by the asset allocation. The equilibrium distortion is type dependent: trade with small surplus breaks down; trade with intermediate surplus may be delayed; trade with large surplus is carried out with a large bid/ask spread but without delay. Because of dealers' limited commitment, the distortions become more severe when the valuation shock is frequent, the valuation dispersion is large or the matching friction to form new relationships is large. Calibrating the model and running a horse race between matching efficiency, trading speed and relationship stability, I found that the liquidity disruption in the market during the recent financial crisis is more consistent with declining matching efficiency of forming trading relationsh

Keywords: screening; liquidity; long-term relationship; over-the-counter markets (search for similar items in EconPapers)
JEL-codes: D82 D83 G1 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-des, nep-dge and nep-mst
Date: 2018-03-01
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Published in Journal of Economic Theory, 1, March, 2018, 174, pp. 16-56. ISSN: 0022-0531

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