Asset Issuance in Over-the-Counter Markets

Abstract

We model asset issuance in over-the-counter markets. Investors buy newly issued assets in a primary market and trade existing assets in a secondary market, where both markets are over the counter. We show that the level of asset issuance and its efficiency depend on how investors split the surplus in secondary market trade. If buyers get most of the surplus in secondary market trade, then sellers do not have incentives to participate in the primary market in order to intermediate assets and the economy has a low level of assets. On the other hand, if sellers get most of the surplus, buyers have strong incentives to participate in the primary market and the economy has a high level of assets. Equilibrium is inefficient for any splitting rule. The result follows from a double-sided hold-up problem in which it is impossible for all investors to take into account the full social value of an asset when trading. We propose a tax/subsidy scheme and show how it restores efficiency. We calibrate our model to match features of the US municipal bond market in order to quantify the effects of the intervention.The intervention leads to large welfare gains and, in response to a financial crisis caused by an aggregate demand shock, makes the crisis less severe and shorter relative to the economy with no intervention. JEL Classification: D53, D82, G14

Market-making with Search and Information Frictions

“…In Afonso (2011), the presence of congestion externalities plays a crucial role. In our paper, the counterintuitive effects stem from the interaction with asymmetric information and learningchannels that are not present in these papers.7 Another, more recent, example isBethune et al (2016).8 This latter feature distinguishes our work from papers that study adverse selection stemming from private information about the idiosyncratic quality of an asset; a non-exhaustive list of papers in this tradition includesCamargo and Lester (2014),Guerrieri and Shimer (2014),Kaya and Kim (2018),Fuchs and Skrzypacz (2015),Chiu and Koeppl (2016),Choi (2016), andKim (2017). In these papers, information revealed from a particular trade is asset-specific and, therefore, is typically not useful in future trades involving other assets.…”

Frictional Intermediation in Over-the-Counter Markets

“…Related contemporaneous work includes Neklyudov (2012), who considers a model with two valuations but introduces heterogeneity in trading speed; the online Appendix of Gavazza (2011), who proposes a model of purely decentralized trade with a continuum of types, subject to search costs, and focuses on the case in which investors trade only once between preference shocks; and Cujean and Praz (2013), who study transparency in OTC markets using a model with a continuum of types and unrestricted asset holdings, where investors are imperfectly informed about the type of their trading partner. More recent work includes Shen, Wei, and Yan (2015), who introduce search costs into our framework; Uslü (2015), who studies heterogenous search intensity, preference shocks, and divisible asset holdings; Sagi (2015), who calibrates a partial equilibrium model with heterogenous types to explain commercial real estate returns; Farboodi, Jarosch, and Shimer (2016), who consider the ex-ante choice of trading speed; Bethune, Sultanum, and Trachter (2016), who introduce private information into our framework of; Farboodi, Jarosch, and Menzio (2018), who consider heterogeneous bargaining power; Zhang (2018), who introduces long-term relationships between customers and dealers; and Liu (2018), who studies the ex-post privately and socially optimal choice of search effort.…”

An Information-Based Theory of Financial Intermediation

“…We consider a version of the model with only experts and uninformed investors. The efficient fraction of experts strikes a balance between two forces: a larger fraction can increase welfare through a lowering the distortion in bilateral trade, but a larger fraction can also decrease welfare through causing a higher distortion in intermediation and issuance incentives, as explored in Bethune et al (2019). We construct numerical examples where this trade-off is apparent.…”