Working Paper: NBER ID: w15414
Authors: Ricardo Lagos; Guillaume Rocheteau; Pierre-Olivier Weill
Abstract: 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.
Keywords: Liquidity Provision; Over-the-Counter Markets; Crisis Management; Government Intervention
JEL Codes: C78; D83; E44; G01
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| severe trading frictions (F12) | dealers not providing liquidity (G24) |
| government intervention (O25) | market allocative efficiency (D61) |
| trading frictions (F12) | dealer behavior (L14) |
| reducing dealers' market power (L42) | market efficiency (G14) |