The Fragility of Discretionary Liquidity Provision: Lessons from the Collapse of the Auction Rate Securities Market

56 Pages Posted: 28 Feb 2011 Last revised: 22 Jul 2022

Multiple version iconThere are 2 versions of this paper

Date Written: February 25, 2011

Abstract

This working paper was written by Song Han (Federal Reserve Board) and Dan Li (Federal Reserve Board).

We study the fragility of discretionary liquidity provision by major financial intermediaries during systemic events. The laboratory of our study is the recent collapse of the auction rate securities (ARS) market. Using a comprehensive dataset constructed from auction reports and intraday transactions data on municipal ARS, we present quantitative evidence that auction dealers acted at their own discretion as “market makers” before the market collapsed. We show that this discretionary liquidity provision greatly affected both net investor demand and auction clearing rates. Importantly, such discretionary liquidity provision is fragile. As auction dealers suffered losses from other financial markets and faced increasing inventory pressure, they stopped making markets. Moreover, the drop in support occurred suddenly, apparently triggered by the unexpected withdrawal of one major broker-dealer.

Keywords: Auction Rate Securities, Uniform-Price Auctions, Liquidity Crisis, Financial Fragility, Market Microstructure, Municipal Bond Pricing

JEL Classification: G01, G12, G24, D44, H74

Suggested Citation

Institute for Monetary and Financial Research, Hong Kong, The Fragility of Discretionary Liquidity Provision: Lessons from the Collapse of the Auction Rate Securities Market (February 25, 2011). Hong Kong Institute for Monetary and Financial Research (HKIMR) Research Paper WP No. 05/2011, Available at SSRN: https://ssrn.com/abstract=1769614 or http://dx.doi.org/10.2139/ssrn.1769614

Hong Kong Institute for Monetary and Financial Research (Contact Author)

(HKIMR) ( email )

Units 1005-1011, 10th Floor, One Pacific Place
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Hong Kong
China

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