Working Paper
Private and Public Liquidity Provision in Over-the-Counter Markets
Abstract: We show that trade frictions in OTC markets result in inefficient private liquidity provision. We develop a dynamic model of market-based financial intermediation with a two-way interaction between primary credit markets and secondary OTC markets. Private allocations are generically inefficient because investors and firms fail to internalize how their actions affect liquidity in secondary markets. This inefficiency can lead to liquidity that is suboptimally low or high compared to the second best. Our analysis provides a rationale for the regulation and public provision of liquidity and the effect of quantitative easing or tightening on capital markets and investment.
Keywords: Liquidity provision; Market liquidity; Over-the-counter markets; OTC; Quantitative easing; Quantitative tightening; Monetary policy normalization;
JEL Classification: E44; G18; G30;
https://doi.org/10.17016/FEDS.2017.033
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File(s): File format is application/pdf https://www.federalreserve.gov/econres/feds/files/2017033pap.pdf
Bibliographic Information
Provider: Board of Governors of the Federal Reserve System (U.S.)
Part of Series: Finance and Economics Discussion Series
Publication Date: 2017-03-29
Number: 2017-033
Pages: 72 pages