Crashes and Recoveries in Illiquid Markets

We study the dynamics of liquidity provision by dealers during an asset market crash, described as a temporary negative shock to investors’aggregate asset demand. We consider a class of dynamic market settings where dealers can trade continuously with each other, while trading between dealers and investors is subject to delays and involves bargaining. We derive conditions on fundamentals, such as preferences, market structure and the characteristics of the market crash (e.g., severity, persistence) under which dealers provide liquidity to investors following the crash. We also characterize the conditions under which dealers’ incentives to provide liquidity are consistent with market e¢ ciency. Keywords: liquidity, asset inventories, execution delays, search, bargaining J.E.L. Classi…cation: C78, D83, E44, G1 We thank Ruilin Zhou for comments and Monica Crabtree-Reusser for editorial assistance. We also thank seminar participants at Mannheim University, the 2006 Workshop on Money, Banking and Payments at the Federal Reserve Bank of Cleveland, the 2007 Midwest Macro Conference, the 2007 Conference on Microfoundations of Markets with Frictions in Montreal, and the 2007 SED meetings. The views expressed herein are those of the authors and not necessarily those of the Federal Reserve Bank of Cleveland or the Federal Reserve System. Lagos thanks the C. V. Starr Center for Applied Economics at NYU for …nancial support. Lagos: New York University, [email protected]. Rocheteau: Federal Reserve Bank of Cleveland and National University of Singapore, [email protected]. Weill: University of California, Los Angeles, [email protected].