Volatility, Volume, Liquidity in Over-The-Counter Markets
A cross-section of assets of heterogenous and stochastic characteristics is traded via a dealer-intermediated OTC. Liquidity shocked holders are subject to asset-specific holding costs (either assumed or induced by boundary conditions) and naturally want to sell assets to buyers who are not liquidity shocked but have holding limits. Under costly random search, market prices (and thus volatility), liquidity and volume are jointly determined in equilibrium. The equilibrium is unique, and can feature a new form of intermediation (“asset exchanges”) between holders of different assets when the natural buying capacity of investors on the sideline is too small. Considering holding costs that are linked to asset volatility via haircuts in collateralized borrowing, a feedback loop between the volatility of asset prices and holding costs arises, amplifying price volatility. Cross-margining can improve asset prices and reduce volatility by weakening this link. Finally, the model delivers a reason why firms want to issue heterogenous instead of homogenous bonds as they lead to a more efficient allocation of cross-sectional liquidity.