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Liquidity Misallocation in an Over-The-Counter Market

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  • Shengxing Zhang

    (New York University)

Abstract

We show that the dispersion of private valuation reduces market liquidity and allocative efficiency of a dynamic OTC market. In this decentralized market, traders have time varying and heterogeneous private value over the asset and dealers act as competing mechanism designers. We characterize the optimal liquidity provision with endogenous valuation, outside options and type distributions. Depending on traders' value, liquidity can be distorted in three ways, trade breakdown, trade delay or price distortion. The three distortions coexist in the equilibrium. Trade with small gain breaks down. Trade with intermediate gain is delayed. And trade with large gain faces largest distortion in price. As the dispersion of private valuation increases, price dispersion increases and trade is more likely to be delayed or break down for any type. Welfare loss increases as dispersion of private value increases. Quantitatively, welfare loss from liquidity misallocation could reach 5%.

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  • Shengxing Zhang, 2012. "Liquidity Misallocation in an Over-The-Counter Market," 2012 Meeting Papers 529, Society for Economic Dynamics.
  • Handle: RePEc:red:sed012:529
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    Cited by:

    1. Julien Hugonnier & Benjamin Lester & Pierre-Olivier Weill, 2018. "Frictional Intermediation in Over-the-counter Markets," NBER Working Papers 24956, National Bureau of Economic Research, Inc.
    2. Ricardo Lagos & Shengxing Zhang, 2015. "Monetary Exchange in Over-the-Counter Markets: A Theory of Speculative Bubbles, the Fed Model, and Self-fulfilling Liquidity Crises," NBER Working Papers 21528, National Bureau of Economic Research, Inc.
    3. Shengxing Zhang & Ricardo Lagos, 2016. "Turnover Liquidity and the Transmission of Monetary Policy," 2016 Meeting Papers 1569, Society for Economic Dynamics.

    More about this item

    JEL classification:

    • D82 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Asymmetric and Private Information; Mechanism Design
    • D83 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Search; Learning; Information and Knowledge; Communication; Belief; Unawareness
    • G1 - Financial Economics - - General Financial Markets

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