Private and public liquidity provision in over-the-counter markets

We show that trade frictions in over-the-counter (OTC) markets result in inefficient private liquidity provision. We develop a dynamic model of market-based financial intermediation with a two-way interaction between primary credit markets and secondary OTC markets. Private allocations are generically inefficient due to a congestion externality operating through market liquidity in the OTC market. This inefficiency can lead to liquidity that is suboptimally low or high compared to the second best, providing a rationale for the regulation and public provision of liquidity. Moreover, our model characterizes a transmission channel of quantitative easing or tightening that operates through liquidity premia.