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Crises and Liquidity in Over-the-Counter Markets

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  • Ricardo Lagos
  • Guillaume Rocheteau
  • Pierre-Olivier Weill

Abstract

We study the efficiency of dealers’ liquidity provision and the desirability of policy intervention in over-the-counter (OTC) markets during crises. Our theory emphasizes two key frictions in OTC markets: finding counterparties takes time, and trade is bilateral, with quantities and prices determined by bargaining. We model a crisis as a negative shock to investors’ asset demands that lasts until a random recovery time. In this context, dealers can provide liquidity to outside investors by acting as counterparties in trades and by accumulating asset inventories. We find that, when frictions are severe, even well capitalized dealers may not find it optimal to accumulate inventories, given that investors choose asset positions that require small reallocations. In such circumstances, the market allocative efficiency can increase if the government steps in, purchases private assets on its own account, and resells them when the economy recovers.

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Bibliographic Info

Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 15414.

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Date of creation: Oct 2009
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Publication status: published as Lagos, Ricardo & Rocheteau, Guillaume & Weill, Pierre-Olivier, 2011. "Crises and liquidity in over-the-counter markets," Journal of Economic Theory, Elsevier, vol. 146(6), pages 2169-2205.
Handle: RePEc:nbr:nberwo:15414

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  1. Ricardo Lagos & Guillaume Rocheteau, 2007. "Search in Asset Markets: Market Structure, Liquidity, and Welfare," American Economic Review, American Economic Association, vol. 97(2), pages 198-202, May.
  2. Antonio Bernardo & Ivo Welch, 2006. "Liquidity and Financial Market Runs," Yale School of Management Working Papers ysm280, Yale School of Management, revised 01 Aug 2003.
  3. Pierre-Olivier Weill & Dimitri Vayanos, 2007. "A Search-Based Theory of the On-the-Run Phenomenon," FMG Discussion Papers dp577, Financial Markets Group.
  4. Hopenhayn, Hugo A. & Werner, Ingrid M., 1996. "Information, Liquidity, and Asset Trading in a Random Matching Game," Journal of Economic Theory, Elsevier, vol. 68(2), pages 349-379, February.
  5. Darrell Duffie & Nicolae Garleanu & Lasse Heje Pedersen, 2005. "Over-the-Counter Markets," Econometrica, Econometric Society, vol. 73(6), pages 1815-1847, November.
  6. Ricardo Lagos & Guillaume Rocheteau & Pierre-Olivier Weill, 2008. "Crashes and Recoveries in Illiquid Markets," NBER Working Papers 14119, National Bureau of Economic Research, Inc.
  7. Pierre-Olivier Weill, 2007. "Leaning Against the Wind," Review of Economic Studies, Oxford University Press, vol. 74(4), pages 1329-1354.
  8. Stephen G. Cecchetti, 2008. "Crisis and Responses: the Federal Reserve and the Financial Crisis of 2007-2008," NBER Working Papers 14134, National Bureau of Economic Research, Inc.
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  15. Ricardo Lagos & Guillaume Rocheteau, 2008. "Liquidity in asset markets with search frictions," Staff Report 408, Federal Reserve Bank of Minneapolis.
  16. Hans R. Stoll, . "The Supply of Dealer Services in Securities Markets," Rodney L. White Center for Financial Research Working Papers 02-78, Wharton School Rodney L. White Center for Financial Research.
  17. Michael J. Fleming & Warren B. Hrung & Frank M. Keane, 2009. "The Term Securities Lending Facility: origin, design, and effects," Current Issues in Economics and Finance, Federal Reserve Bank of New York, vol. 15(Feb).
  18. Freeman, Scott, 1999. "Rediscounting under aggregate risk," Journal of Monetary Economics, Elsevier, vol. 43(1), pages 197-216, February.
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  20. Freeman, Scott, 1996. "The Payments System, Liquidity, and Rediscounting," American Economic Review, American Economic Association, vol. 86(5), pages 1126-38, December.
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