Reputation and Liquidity in Over-The-Counter (OTC) Markets

Many small over-the-counter (OTC) markets with thinly-traded assets are prone to episodic volatility and market failure due to their high potential for predatory activity. The traders in these markets constitute a tight oligopoly and liquidity events become known to all parties quickly. However, these markets appear to function at relatively low spreads and market failure is rare. We show that large market participants find it optimal to cooperate in a repeated game in which participants implicitly agree not to predate each other during liquidity events. Cooperation fails with extremely large liquidity events, which leads to occasional episodic volatility. We consider an extension that involves cooperation over several markets which leads to contagion during liquidity shocks. Our work suggests that the level of predatory behavior present in financial markets is related to the amount of liquidity present in these markets.