When failure is an option: Fragile liquidity in over-the-counter markets

Terrence Hendershott; Dan Li; Dmitry Livdan; Norman Schürhoff

doi:10.1016/j.jfineco.2024.103859

Journal of Financial Economics Vol. 157 2024

When failure is an option: Fragile liquidity in over-the-counter markets

Terrence Hendershott¹; Dan Li ^2,3; Dmitry Livdan^1,4; Norman Schürhoff^5,6,4

¹ University of California, Berkeley · ² Federal Reserve Board of Governors · ³ Federal Reserve · ⁴ Centre for Economic Policy Research · ⁵ University of Lausanne · ⁶ Swiss Finance Institute

open access

Abstract

Markets can give false impressions of liquidity and stability if failed attempts to trade are ignored. For collateralized loan obligations, we quantify this bias by estimating the total cost of immediacy (TCI) which incorporates failure rates and failure costs. TCI is substantially higher than the observed cost, 0.3–3.8% versus 0.04–0.12% across credit-quality tranches because trade failures are frequent, failure costs are large, and failure costs and rates are correlated. TCI is almost double the realized gains from trade for low-rated tranches. Overall, auction-based over-the-counter markets become illiquid and fragile, especially during stressful periods for low-rated assets.

DOI: 10.1016/j.jfineco.2024.103859
Volume: 157
Pages: 103859
Language: en
Sources: openalex crossref bibtex:phds-export.bib

When failure is an option: Fragile liquidity in over-the-counter markets

Abstract

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