Working Paper

Inventory, Market Making, and Liquidity in OTC Markets


Abstract: We develop a search-theoretic model of a dealer-intermediated over-the-counter market. Our key departure from the literature is to assume that, when a customer meets a dealer, the dealer can sell only assets that it already owns. Hence, in equilibrium, dealers choose to hold inventory. We derive the equilibrium relationship between dealers’ costs of holding assets on their balance sheets, their optimal inventory holdings, and various measures of liquidity, including bid-ask spreads, trade size, volume, and turnover. Using transaction-level data from the corporate bond market, we calibrate the model to quantitatively assess the impact of post-crisis regulations on dealers’ inventory costs, liquidity, and welfare.

Keywords: Over-the-counter markets; intermediation; liquidity; dealer inventory; financial regulation;

JEL Classification: G11; G12; G21;

https://doi.org/10.21799/frbp.wp.2024.22

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Bibliographic Information

Provider: Federal Reserve Bank of Philadelphia

Part of Series: Working Papers

Publication Date: 2024-12-09

Number: 24-22