Liquidity in the Cross Section of OTC Assets

Abstract

We construct a dynamic model of a multi-asset over-the-counter (OTC) market that operates via search and bargaining and empirically test its implications using data from the US corporate bond market. The key novelty in our model is that investors can hold and manage portfolios of OTC-traded assets. We characterize the stationary equilibrium in closed form which includes investors' valuations, terms of trade, and the characteristic function of the distribution of investors' asset positions. Tractability of the model allows us to derive natural proxies for important measures of market liquidity such as trade volume, price dispersion, and price impact. Among other within-market and cross-market comparative statics, we find that the alleviation of search frictions in one market may lead to opposite observations regarding liquidity in other markets depending on which liquidity measure is used. For example, a reduction of search frictions in one market decreases trade volume in other markets implying lower liquidity. At the same time, it decreases price dispersion and price impact implying higher liquidity. We test empirically these key liquidity equations, which uncover the determinants of endogenous liquidity differentials across OTC assets. Overall, our empirical results indicate significant support for the search-and-bargaining framework. Finally, we argue that, among the liquidity measures we analyze, price impact can serve as a good measure of welfare loss caused by OTC frictions, while other measures overstate or understate this deadweight loss.