Trade Delay, Liquidity, and Asset Prices in Over-the-Counter Markets

In over-the-counter markets, the presence of two frictions is central to determine prices, liquidity, and efficiency: the search friction reflected in how long it takes to find a trading opportunity and the bargaining friction reflected in how promptly gains from trade are realized once the opportunity is identified. This paper captures both frictions by introducing an asset-specific trade delay into a standard search-and-bargaining model. For both exogenous and endogenous specifications of delay, the set of traded assets and the dependence of asset prices and spreads on default risk, liquidity, and market conditions are determined in equilibrium. The proposed model with endogenous delay has several implications. First, it offers a novel testable prediction: for assets within the same credit rating class, the liquidity is U-shaped in quality. Assets closer to the extremes of the quality range are more liquid, while assets in the middle of the quality range may be not traded at all. This is in contrast with a monotone relation in models with asymmetric information. Second, this model shows that the reduction in search and bargaining frictions may have opposite effects on market liquidity which is reflected in the range of traded assets. Finally, it establishes a connection between market uncertainty about the asset payoff and market liquidity. This link sheds light on the role of transparency in over-the-counter markets and explains the occurrence of dried-up liquidity and flights-to-quality during periods of increased market uncertainty.