Liquidity misallocation in an over-the-counter market

Abstract

To understand the illiquidity of the over-the-counter market when dealers and traders are in long-term relationships, I develop a framework to study the endogenous liquidity distortions resulting from the profit-maximizing, screening behavior of dealers. The dealer offers the trading mechanism contingent on the aggregate history of his customers summarized by the asset allocation. The equilibrium distortion is type dependent: trade with small surplus breaks down; trade with intermediate surplus may be delayed; trade with large surplus is carried out with a large bid/ask spread but without delay. Because of dealers' limited commitment, the distortions become more severe when the valuation shock is frequent, the valuation dispersion is large or the matching friction to form new relationships is large. Calibrating the model and running a horse race between matching efficiency, trading speed and relationship stability, I found that the liquidity disruption in the market during the recent financial crisis is more consistent with declining matching efficiency of forming trading relationships. The optimal mechanism can be implemented by random quote posting.

Tunisian corporate bond market liquidity: a qualitative approach

“…Several researchers suggest that the OTC market negatively affects market liquidity. According to Zhang (2018), many OTC markets are illiquid, with high bid-ask spreads and long trade delays. This has been confirmed empirically by Hasnawati (2020), who attributes the Indonesian corporate bond market's illiquidity to the OTC structure.…”

Periodic, Complete‐participation Trade in the Lagos‐rocheteau Model

“…For example, Tsoy () studies the effect of large quantities on the price; Acharya and Bisin (), Arora et al. (), He and Milbradt () and Tsoy () study counterparty risk and the credibility of their counter‐parties that arise from the fact that trades are agreed to before they are executed; and Chiu and Koeppl (), Glode and Opp (), Guerrieri and Shimer () and Zhang () study asymmetric information about the securities being traded, among others.…”