IDEAS home Printed from https://ideas.repec.org/p/boe/boeewp/0979.html
   My bibliography  Save this paper

A structural model of liquidity in over‑the‑counter markets

Author

Listed:
  • Coen, Jamie

    (Bank of England)

  • Coen, Patrick

    (Toulouse School of Economics)

Abstract

We study how firm heterogeneity determines liquidity in over‑the‑counter markets. Using a rich data set on trading in the secondary market for sterling corporate bonds, we build and estimate a flexible model of search and trading in which firms have heterogeneous search costs. We show that the 8% most active traders supply as much liquidity as the remaining 92%. Liquidity is thus vulnerable to shocks to these firms: if the 4% most active traders stop trading, liquidity falls by over 60%. Bank capital regulation reduces the willingness of these active traders to hold assets and thus reduces liquidity. However, trader search, holdings and intermediation respond endogenously to reduce the welfare costs of regulation by 30%. These costs are greater in a stress, when these margins of adjustment are constrained. The introduction of trading platforms, which homogenise the ability of traders to trade frequently, improves aggregate welfare but harms the most active traders who currently profit from supplying liquidity.

Suggested Citation

  • Coen, Jamie & Coen, Patrick, 2022. "A structural model of liquidity in over‑the‑counter markets," Bank of England working papers 979, Bank of England.
    • Handle: RePEc:boe:boeewp:0979
    as

    Download full text from publisher

    File URL: https://www.bankofengland.co.uk/-/media/boe/files/working-paper/2022/a-structural-model-of-liquidity-in-over-the-counter-markets.pdf
    File Function: Full text
    Download Restriction: no
    ---><---

    References listed on IDEAS

    as
    1. Alessandro Gavazza, 2016. "An Empirical Equilibrium Model of a Decentralized Asset Market," Econometrica, Econometric Society, vol. 84, pages 1755-1798, September.
    2. Daniel Heller & Nicholas Vause, 2012. "Collateral requirements for mandatory central clearing of over-the-counter derivatives," BIS Working Papers 373, Bank for International Settlements.
    3. Gromb, Denis & Vayanos, Dimitri, 2002. "Equilibrium and welfare in markets with financially constrained arbitrageurs," Journal of Financial Economics, Elsevier, vol. 66(2-3), pages 361-407.
    4. Bruno Biais & Fany Declerck & Sophie Moinas, 2016. "Who supplies liquidity, how and when?," BIS Working Papers 563, Bank for International Settlements.
    5. Markus K. Brunnermeier & Lasse Heje Pedersen, 2009. "Market Liquidity and Funding Liquidity," The Review of Financial Studies, Society for Financial Studies, vol. 22(6), pages 2201-2238, June.
    6. Bessembinder, Hendrik & Spatt, Chester & Venkataraman, Kumar, 2020. "A Survey of the Microstructure of Fixed-Income Markets," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 55(1), pages 1-45, February.
    7. Myers, Stewart C. & Majluf, Nicholas S., 1984. "Corporate financing and investment decisions when firms have information that investors do not have," Journal of Financial Economics, Elsevier, vol. 13(2), pages 187-221, June.
    8. Jason Allen & Milena Wittwer, 2023. "Centralizing Over-the-Counter Markets?," Journal of Political Economy, University of Chicago Press, vol. 131(12), pages 3310-3351.
    9. Artem Neklyudov, 2019. "Bid-Ask Spreads and the Over-the-Counter Interdealer Markets: Core and Peripheral Dealers," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 33, pages 57-84, July.
    10. Darrell Duffie, 2010. "Presidential Address: Asset Price Dynamics with Slow‐Moving Capital," Journal of Finance, American Finance Association, vol. 65(4), pages 1237-1267, August.
    11. Foucault, Thierry & Pagano, Marco & Roell, Ailsa, 2013. "Market Liquidity: Theory, Evidence, and Policy," OUP Catalogue, Oxford University Press, number 9780199936243.
    12. Douglas W. Diamond & Raghuram G. Rajan, 2001. "Liquidity Risk, Liquidity Creation, and Financial Fragility: A Theory of Banking," Journal of Political Economy, University of Chicago Press, vol. 109(2), pages 287-327, April.
    13. Stewart C. Myers & Nicholas S. Majluf, 1984. "Corporate Financing and Investment Decisions When Firms Have InformationThat Investors Do Not Have," NBER Working Papers 1396, National Bureau of Economic Research, Inc.
    14. Ricardo Lagos & Guillaume Rocheteau, 2007. "Search in Asset Markets: Market Structure, Liquidity, and Welfare," American Economic Review, American Economic Association, vol. 97(2), pages 198-202, May.
    15. Bajaj , Rasna & Binmore, Andrew & Dasgupta, Rupak & Vo, Quynh-Anh, 2018. "Banks’ internal capital markets: how do banks allocate capital internally?," Bank of England Quarterly Bulletin, Bank of England, vol. 58(2), pages 1-10.
    16. Anat R. Admati & Peter M. DeMarzo & Martin F. Hellwig & Paul Pfleiderer, 2013. "Fallacies, Irrelevant Facts, and Myths in the Discussion of Capital Regulation: Why Bank Equity is Not Socially Expensive," Discussion Paper Series of the Max Planck Institute for Research on Collective Goods 2013_23, Max Planck Institute for Research on Collective Goods.
    17. Mallaburn, David & Roberts-Sklar, Matt & Silvestri, Laura, 2019. "Resilience of trading networks: evidence from the sterling corporate bond market," Bank of England working papers 813, Bank of England.
    Full references (including those not matched with items on IDEAS)

    Citations

    Citations are extracted by the CitEc Project, subscribe to its RSS feed for this item.
    as


    Cited by:

    1. Shuo Liu, 2024. "Social Optimal Search Intensity in Over-the-Counter Markets," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 53, pages 224-282, July.

    Most related items

    These are the items that most often cite the same works as this one and are cited by the same works as this one.
    1. Christoph Bertsch & Mike Mariathasan, 2021. "Optimal bank leverage and recapitalization in crowded markets," BIS Working Papers 923, Bank for International Settlements.
    2. Strobl, Günter, 2022. "A theory of procyclical market liquidity," Journal of Economic Dynamics and Control, Elsevier, vol. 138(C).
    3. Andrei Shleifer & Robert Vishny, 2011. "Fire Sales in Finance and Macroeconomics," Journal of Economic Perspectives, American Economic Association, vol. 25(1), pages 29-48, Winter.
    4. Abbassi, Puriya & Iyer, Rajkamal & Peydró, José-Luis & Tous, Francesc R., 2016. "Securities trading by banks and credit supply: Micro-evidence from the crisis," Journal of Financial Economics, Elsevier, vol. 121(3), pages 569-594.
    5. Ansgar Walther, 2016. "Jointly Optimal Regulation of Bank Capital and Liquidity," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 48(2-3), pages 415-448, March.
    6. Saki Bigio & Adrien d'Avernas, 2021. "Financial Risk Capacity," American Economic Journal: Macroeconomics, American Economic Association, vol. 13(4), pages 142-181, October.
    7. Tobias Adrian & Hyun Song Shin, 2014. "Procyclical Leverage and Value-at-Risk," The Review of Financial Studies, Society for Financial Studies, vol. 27(2), pages 373-403.
    8. Choi, Dong Beom & Eisenbach, Thomas M. & Yorulmazer, Tanju, 2021. "Watering a lemon tree: Heterogeneous risk taking and monetary policy transmission," Journal of Financial Intermediation, Elsevier, vol. 47(C).
    9. Lewis, Kurt F. & Longstaff, Francis A. & Petrasek, Lubomir, 2021. "Asset mispricing," Journal of Financial Economics, Elsevier, vol. 141(3), pages 981-1006.
    10. Iyer, Rajkamal & Peydró, José-Luis & Abbassi, Puriya & Tous, Francesc, 2015. "Securities Trading by Banks and Credit Supply: Micro-Evidence," CEPR Discussion Papers 10480, C.E.P.R. Discussion Papers.
    11. de Bandt, Olivier & Camara, Boubacar & Maitre, Alexis & Pessarossi, Pierre, 2018. "Optimal capital, regulatory requirements and bank performance in times of crisis: Evidence from France," Journal of Financial Stability, Elsevier, vol. 39(C), pages 175-186.
    12. Weill, Pierre-Olivier, 2020. "The search theory of OTC markets," CEPR Discussion Papers 14847, C.E.P.R. Discussion Papers.
    13. Hanson, Samuel G. & Sunderam, Adi, 2013. "Are there too many safe securities? Securitization and the incentives for information production," Journal of Financial Economics, Elsevier, vol. 108(3), pages 565-584.
    14. Simsek, Alp, 2012. "Belief Disagreements and Collateral Constraints," Scholarly Articles 9561259, Harvard University Department of Economics.
    15. Philippe Oster, 2020. "Contingent Convertible bond literature review: making everything and nothing possible?," Journal of Banking Regulation, Palgrave Macmillan, vol. 21(4), pages 343-381, December.
    16. Stijn Claessens & M Ayhan Kose, 2018. "Frontiers of macrofinancial linkages," BIS Papers, Bank for International Settlements, number 95.
    17. Senarathne, Chamil W., . "The Information Flow Interpretation of Margin Debt Value Data: Evidence from New York Stock Exchange," Asian Journal of Applied Economics, Kasetsart University, Center for Applied Economics Research, vol. 26(1).
    18. Abbassi, Puriya & Iyer, Rajkamal & Peydró, José-Luis & Tous, Francesc R., 2016. "Securities trading by banks and credit supply: Micro-evidence from the crisis," Journal of Financial Economics, Elsevier, vol. 121(3), pages 569-594.
    19. Ansgar Walther, 2014. "Jointly optimal regulation of bank capital and maturity structure," Economics Series Working Papers 725, University of Oxford, Department of Economics.
    20. Tobias Adrian & Hyun Song Shin, 2008. "Financial intermediary leverage and value at risk," Staff Reports 338, Federal Reserve Bank of New York.

    More about this item

    Keywords

    Liquidity; over‑the‑counter markets; financial intermediation.;
    All these keywords.

    JEL classification:

    • D83 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Search; Learning; Information and Knowledge; Communication; Belief; Unawareness
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • L51 - Industrial Organization - - Regulation and Industrial Policy - - - Economics of Regulation

    NEP fields

    This paper has been announced in the following NEP Reports:

    Statistics

    Access and download statistics

    Corrections

    All material on this site has been provided by the respective publishers and authors. You can help correct errors and omissions. When requesting a correction, please mention this item's handle: RePEc:boe:boeewp:0979. See general information about how to correct material in RePEc.

    If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

    If CitEc recognized a bibliographic reference but did not link an item in RePEc to it, you can help with this form .

    If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your RePEc Author Service profile, as there may be some citations waiting for confirmation.

    For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: Digital Media Team (email available below). General contact details of provider: https://edirc.repec.org/data/boegvuk.html .

    Please note that corrections may take a couple of weeks to filter through the various RePEc services.

    IDEAS is a RePEc service. RePEc uses bibliographic data supplied by the respective publishers.