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Inventory, market making, and liquidity in OTC markets

Author

Listed:
  • Cohen, Assa
  • Kargar, Mahyar
  • Lester, Benjamin
  • Weill, Pierre-Olivier

Abstract

We develop a search-theoretic model of a dealer-intermediated over-the-counter market. Our key departure from the literature is to assume that, when a customer meets a dealer, the dealer can sell only assets that it already owns. Hence, in equilibrium, dealers choose to hold inventory. We derive the equilibrium relationship between dealers' costs of holding assets on their balance sheets, their optimal inventory holdings, and various measures of liquidity, including bid-ask spreads, trade size, volume, and turnover. Using transaction-level data from the corporate bond market, we calibrate the model to quantitatively assess the impact of post-crisis regulations on dealers' inventory costs, liquidity, and welfare.

Suggested Citation

  • Cohen, Assa & Kargar, Mahyar & Lester, Benjamin & Weill, Pierre-Olivier, 2024. "Inventory, market making, and liquidity in OTC markets," Journal of Economic Theory, Elsevier, vol. 222(C).
    • Handle: RePEc:eee:jetheo:v:222:y:2024:i:c:s0022053124001236
    DOI: 10.1016/j.jet.2024.105917
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    More about this item

    Keywords

    Over-the-counter markets; Intermediation; Liquidity; Dealer inventory; Financial regulation;
    All these keywords.

    JEL classification:

    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages

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