Illiquidity Spirals in Coupled Over-the-Counter Markets*

Traders provide intermediation of two related financial assets—secured debt and the underlying collateral. Each asset is traded in its own over-the-counter trading network. Traders decide whether or not to be active in each network. We give conditions under which the financial connections between the two assets make this a game of strategic complements on two coupled networks: incentives to be active in a given network are increasing both in neighbors’ activity choices in that network and in one’s own activity in the other network. Providing the first analysis of such network games, we use the theory of fixed points of monotone functions to characterize the general structure of equilibria in such systems. We focus on illiquidity spirals: following an exogenous shock disabling some intermediaries, a sequence of withdrawals occurs, corresponding to a contagion across the two networks. For a class of market structures associated with random graphs, liquidity changes discontinuously in the size of an exogenous shock, in contrast to standard models of network contagion.