Working Paper: NBER ID: w17500
Authors: Yiting Li; Guillaume Rocheteau; Pierre-Olivier Weill
Abstract: We study an over-the-counter (OTC) market with bilateral meetings and bargaining where the usefulness of assets, as means of payment or collateral, is limited by the threat of fraudulent practices. We assume that agents can produce fraudulent assets at a positive cost, which generates endogenous upper bounds on the quantity of each asset that can be sold, or posted as collateral in the OTC market. Each endogenous, asset-specific, resalability constraint depends on the vulnerability of the asset to fraud, on the frequency of trade, and on the current and future prices of the asset. In equilibrium, the set of assets can be partitioned into three liquidity tiers, which differ in their resalability, their prices, their sensitivity to shocks, and their responses to policy interventions. The dependence of an asset's resalability on its price creates a pecuniary externality, which leads to the result that some policies commonly thought to improve liquidity can be welfare reducing.
Keywords: liquidity; fraud; asset pricing; OTC market; policy interventions
JEL Codes: E41; E44; E5; E58; G1; G12
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| threat of fraud (K42) | asset-specific endogenous resalability constraints (D25) |
| asset-specific endogenous resalability constraints (D25) | how assets can be traded in over-the-counter (OTC) markets (G10) |
| quantity of an asset offered (G19) | trade rejection due to fears of fraud (F31) |
| vulnerability to fraud (K24) | liquidity of an asset (E41) |
| liquidity of an asset (E41) | varying prices and liquidity measures across assets with identical cash flows (G19) |
| policies aimed at improving liquidity (G28) | opposite effect on welfare (D69) |
| market shocks (G17) | flight to liquidity (G33) |
| flight to liquidity (G33) | widening yield spread between liquid and less liquid assets (G19) |