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The Fragility of Discretionary Liquidity Provision: Lessons from the Collapse of the Auction Rate Securities Market

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  • Song Han

    (Federal Reserve Board and Hong Kong Institute for Monetary Research)

  • Dan Li

    (Federal Reserve Board)

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    Abstract

    We 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 Info

    Paper provided by Hong Kong Institute for Monetary Research in its series Working Papers with number 052011.

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    Length: 56 pages
    Date of creation: Feb 2011
    Date of revision:
    Handle: RePEc:hkm:wpaper:052011

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    Related research

    Keywords: Auction Rate Securities; Uniform-Price Auctions; Liquidity Crisis; Financial Fragility; Market Microstructure; Municipal Bond Pricing;

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    1. de Bandt, Olivier & Hartmann, Philipp, 2000. "Systemic Risk: A Survey," CEPR Discussion Papers, C.E.P.R. Discussion Papers 2634, C.E.P.R. Discussion Papers.
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    9. Covitz, Daniel & Liang, Nellie & Suarez, Gustavo, 2009. "The anatomy of a financial crisis: the evolution of panic-driven runs in the asset-backed commercial paper market," Proceedings, Federal Reserve Bank of San Francisco, Federal Reserve Bank of San Francisco, issue Jan, pages 1-36.
    10. Cass, David & Shell, Karl, 1983. "Do Sunspots Matter?," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 91(2), pages 193-227, April.
    11. Detragiache, Enrica & Garella, Paolo & Guiso, Luigi, 1997. "Multiple Versus Single Banking Relationships," CEPR Discussion Papers, C.E.P.R. Discussion Papers 1649, C.E.P.R. Discussion Papers.
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