Private and Public Liquidity Provision in Over-the-Counter Markets
David Rappoport and
No 2017-033, Finance and Economics Discussion Series from Board of Governors of the Federal Reserve System (US)
We show that trade frictions in OTC markets result in inefficient private liquidity provision. We develop a dynamic model of market-based financial intermediation with a two-way interaction between primary credit markets and secondary OTC markets. Private allocations are generically inefficient because investors and firms fail to internalize how their actions affect liquidity in secondary markets. This inefficiency can lead to liquidity that is suboptimally low or high compared to the second best. Our analysis provides a rationale for the regulation and public provision of liquidity and the effect of quantitative easing or tightening on capital markets and investment.
Keywords: Liquidity provision; Market liquidity; Over-the-counter markets; OTC; Quantitative easing; Quantitative tightening; Monetary policy normalization (search for similar items in EconPapers)
JEL-codes: E44 G18 G30 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-ban and nep-mac
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