Liquidity Misallocation in an Over-the-Counter Market

Abstract

To understand the illiquidity of the over-the-counter market when dealers and traders are in long-term relationships, I develop a framework to study the endogenous liquidity distortions resulting from the profit-maximizing, screening behavior of dealers. The dealer offers the trading mechanism contingent on the aggregate history of his customers summarized by the asset allocation. The equilibrium distortion is type dependent: trade with small surplus breaks down; trade with intermediate surplus is delayed; trade with large surplus is carried out with a large bid/ask spread but without delay. The distortions become more severe when the valuation shock is frequent, the valuation dispersion is large or the matching friction to form new relationships is large. Implications on the dealer's quoting strategy and asset pricing are also discussed.