Pricing and Liquidity in Over-the-Counter Markets

Abstract

I show that if dealers are averse to holding inventory, then prices, liquidity, and dealers' inventory positions depend on inventory costs in negotiated over-the-counter markets. The solution to my dynamic equilibrium model rationalizes the following stylized facts in the US corporate bond market:(i) a reduction in dealers' inventories during crises;(ii) a reduction in average trade size since the onset of the financial crisis and tighter regulatory environment;(iii) better prices for customers to buy than sell in the financial crisis;(iv) a generally negative relationship between transaction costs and trade size.The results inform debate on the Volcker Rule.