Liquidity Misallocation in an Over-The-Counter Market

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%.