Firms raise money from banks and the bond market. Banks sell loans in a secondary market to recycle their funds or to trade on private information. Liquidity in the loan market depends on the relative likelihood of each motive for trade and affects firms' optimal financial structure. The endogenous degree of liquidity is not always socially optimal: There is excessive trade in highly rated names, and insufficient liquidity in riskier bonds. We provide testable implications for prices and quantities in primary and secondary loan markets, and bond markets. Further, we posit that risk-based capital requirements may be socially desirable.THE TERM "COLLATERALIZED LOAN OBLIGATIONS" (CLOs) was coined in 1989, when corporate loans were first used as collateral in Collateralized Debt Obligations (CDOs).1 Since then, the growth in loan sales has been enormous. According to Lucas et al. (2006) 2 If a bank securitizes or sells a loan that it originated, it is buying insurance on credit events over which it has either more control or more information than the buyer.In the face of this informational friction, why did the secondary market for corporate loans develop in the 1990s? What effect has this had on relationship banking? In this paper, we characterize when a liquid secondary market for loans arises, when a liquid secondary loan market is socially desirable, and we provide testable predictions on the effect of the emergence of this market on prices and quantities in bond and primary loan markets. Our predictions are based on both changes in the parameters that lead to higher loan liquidity and changes in the contracts that are written between banks and firms given this higher liquidity.
We model a dynamic limit order market as a stochastic sequential game with rational traders. Since the model is analytically intractable, we provide an algorithm based on Pakes and McGuire (2001) to find a stationary Markov-perfect equilibrium. We then generate artificial time series and perform comparative dynamics. Conditional on a transaction, the midpoint of the quoted prices is not a good proxy for the true value. Further, transaction costs paid by market order submitters are negative on average, and negatively correlated with the effective spread. Reducing the tick size is not Pareto improving but increases total investor surplus. Copyright 2005 by The American Finance Association.
We present a microstructure model of competition for order flow between exchanges based on liquidity provision. We find that neither a pure limit order market (PLM) nor a hybrid specialist/limit order market (HM) structure is competition-proof. A PLM can always be supported in equilibrium as the dominant market (i.e., where the hybrid limit book is empty), but an HM can also be supported, for some market parameterizations, as the dominant market. We also show the possible coexistence of competing markets. Order preferencing-that is, decisions about where orders are routed when investors are indifferent-is a key determinant of market viability. Welfare comparisons show that competition between exchanges can increase as well as reduce the cost of liquidity. Active competition between exchanges for order flow in cross-listed securities is intense in the current financial marketplace. Examples include rivalries between the New York Stock Exchange (NYSE), crossing networks, and ECNs and between the London Stock Exchange, the Paris Bourse, and other continental markets for equity trading and between Eurex and London International Financial Futures and Options Exchange (LIFFE) for futures volume. While exchanges compete along many dimensions (e.g., "payment for order flow," transparency, execution speed), liquidity and "price improvement" will, in our view, be the key variables driving competition in the future. Over time, high-cost markets should be driven out of business as investors switch to cheaper trading venues. Moreover, "market structure" is increasingly singled out by regulators, exchanges, and other market participants as a major determinant of liquidity. 1 We thank the editor, Larry Glosten, for many helpful insights and suggestions. We also benefited from comments from
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