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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
  • Dan Li

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.

Suggested Citation

  • Song Han & Dan Li, 2010. "The fragility of discretionary liquidity provision - lessons from the collapse of the auction rate securities market," Finance and Economics Discussion Series 2010-50, Board of Governors of the Federal Reserve System (U.S.).
  • Handle: RePEc:fip:fedgfe:2010-50
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    More about this item

    Keywords

    Securities ; Auctions ; Municipal bonds ; Liquidity (Economics);

    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, Pricing, and Design - - - Auctions
    • H74 - Public Economics - - State and Local Government; Intergovernmental Relations - - - State and Local Borrowing

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