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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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number
15414.
Length: Date of creation: Oct 2009 Date of revision: Handle: RePEc:nbr:nberwo:15414
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Find related papers by JEL classification: C78 - Mathematical and Quantitative Methods - - Game Theory and Bargaining Theory - - - Bargaining Theory; Matching Theory D83 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Search, Learning, and Information E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy G01 - Financial Economics - - General - - - Financial Crises
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Grossman, S.J. & Miller, M.H., 1988.
"Liquidity And Market Structure,"
Papers
88, Princeton, Department of Economics - Financial Research Center.
Other versions:
Darrell Duffie & Nicolae Garleanu & Lasse Heje Pedersen, 2005.
"Over-the-Counter Markets,"
Econometrica,
Econometric Society, vol. 73(6), pages 1815-1847, November.
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Darrell Duffie & Nicolae Garleanu & Lasse Heje Pedersen, 2004.
"Over-the-Counter Markets,"
NBER Working Papers
10816, National Bureau of Economic Research, Inc.
[Downloadable!] (restricted)