The Fragility of Discretionary Liquidity Provision: Lessons from the Collapse of the Auction Rate Securities Market
AbstractWe study the fragility of discretionary liquidity provision by major financial intermediaries during systemic events. The laboratory of our study is the recent collapse of the auction rate securities (ARS) market. Using a comprehensive dataset constructed from auction reports and intraday transactions data on municipal ARS, we present quantitative evidence that auction dealers acted at their own discretion as "market makers" before the market collapsed. We show that this discretionary liquidity provision greatly affected both net investor demand and auction clearing rates. Importantly, such discretionary liquidity provision is fragile. As auction dealers suffered losses from other financial markets and faced increasing inventory pressure, they stopped making markets. Moreover, the drop in support occurred suddenly, apparently triggered by the unexpected withdrawal of one major broker-dealer.
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Bibliographic InfoPaper provided by Hong Kong Institute for Monetary Research in its series Working Papers with number 052011.
Length: 56 pages
Date of creation: Feb 2011
Date of revision:
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Auction Rate Securities; Uniform-Price Auctions; Liquidity Crisis; Financial Fragility; Market Microstructure; Municipal Bond Pricing;
Find related papers by JEL classification:
- G01 - Financial Economics - - General - - - Financial Crises
- G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
- G24 - Financial Economics - - Financial Institutions and Services - - - Investment Banking; Venture Capital; Brokerage
- D44 - Microeconomics - - Market Structure and Pricing - - - Auctions
- H74 - Public Economics - - State and Local Government; Intergovernmental Relations - - - State and Local Borrowing
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