Crises and Liquidity in over-the-Counter Markets

Examination Paper - Summary of:

Crises and liquidity in over-the-counter markets∗

by Ricardo Lagos, Guillaume Rocheteau and Pierre-Olivier Weill

Gion Donat Piras January 11, 2013

1 Introduction

In over-the-counter (OTC) markets investors must search for a counterparty before trad- ing. Broker-dealers provide liquidity to investors by matching buyers and sellers or some- times by trading on their own account. This liquidity provision became critical in times of large market imbalances. Many financial instruments of the recent financial crisis became illiquid. The subsequent disruptions initiated the Federal Reserve to purchase assets on its own account in some markets. The paper studies the efficiency of dealers’ liquidity provision and desirability of policy intervention in OTC markets during times of crisis. The analysis of the paper concludes that “dealers will be unwilling to provide liquidity when trading frictions are severe - even when the opposite would be socially efficient and even if dealers are well-capitalized.” And that ”government can improve efficiency in the midst of a financial crisis by purchasing assets on its own account in order to resell them when the market recovers, thereby acting as a liquidity provider of last resort.”

The authors will use a search-theoretic model of financial markets focusing on the search and bargaining frictions of OTC markets. Investors receive random trading op- portunities with dealers who are able to trade continuously with each other in a Walrasian market. A crisis is modeled by an aggregate shock that reduces investors’ willingness to hold assets.

Previous research on dealership markets with an inventory-theoretic approach had been done by Amihud and Mendelson (1980), Ho and Stoll (1983) and Stoll (1978). Re- cent research model competitive dealers providing liquidity in order to share risk with investors. Huang and Wang (2010) endogenize supply and demand of liquidity via partic- ipation costs....