A Structural Model of Liquidity in Over‑The‑Counter Markets

62 Pages Posted: 8 Jun 2022

See all articles by Jamie Coen

Jamie Coen

Bank of England

Patrick Coen

London School of Economics & Political Science (LSE) - London School of Economics

Date Written: May 13, 2022

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.

Keywords: Liquidity, over‑the‑counter markets, financial intermediation

JEL Classification: G12, L51, D83

Suggested Citation

Coen, Jamie and Coen, Patrick, A Structural Model of Liquidity in Over‑The‑Counter Markets (May 13, 2022). Bank of England Working Paper No. 979, 2022, Available at SSRN: https://ssrn.com/abstract=4130489 or http://dx.doi.org/10.2139/ssrn.4130489

Jamie Coen (Contact Author)

Bank of England ( email )

Threadneedle Street
London, EC2R 8AH
United Kingdom

Patrick Coen

London School of Economics & Political Science (LSE) - London School of Economics ( email )

United Kingdom

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