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Crises and Liquidity in Over-the-Counter Markets

Listed author(s):
  • Ricardo Lagos
  • Guillaume Rocheteau
  • Pierre-Olivier Weill

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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File URL: http://www.nber.org/papers/w15414.pdf
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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
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
Note: AP EFG ME
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