Non-Traded Assets in Over-the-Counter Markets

Project Information

NTAOTC

Grant agreement ID: 101075924

DOI

10.3030/101075924

EC signature date 22 November 2022

Start date 1 May 2023

End date 30 April 2028

Funded under

• European Research Council (ERC)

Total cost

€ 1 416 812,50

EU contribution

€ 1 416 812,50

Coordinated by

UNIVERSITA COMMERCIALE LUIGI BOCCONI
Italy

Periodic Reporting for period 1 - NTAOTC (Non-Traded Assets in Over-the-Counter Markets)

Reporting period: 2023-05-01 to 2025-10-31

Summary of the context and overall objectives of the project

The goal is to understand why so many assets in over-the-counter (OTC) markets trade infrequently. There could be several reasons why assets trade infrequently, and thus many potential questions arise in this context. What is the role of search frictions for illiquid assets? For example, do certain market participants find it difficult to trade because they can't find counterparties? Does a switch from bilateral to electronic trading help to reduce search frictions? Do financial intermediaries affect the illiquidity of assets? For example, if intermediaries get constrained then it might be harder for them to commit capital and thus to provide liquidity. Another angle is that illiquid assets could be driven by firms desire to supply them. This could be the case if firms prefer a stable investor base in order to better renegotiate contract terms. Illiquid assets could also emerge if loan-dependent firms are pushed into the bond market; for example, because bank regulation makes it more costly for banks to supply credit.

The aim of the project is thus to understand in a comprehensive way the emergence of illiquid assets in OTC markets. There is a policy discussion whether one should abolish OTC markets and make them more centralized, in order to improve the liquidity of assets. To guide that discussion, one needs to have a better understanding about the frictions that drive intermediation in OTC markets. The project will thus help to guide policy-related discussions.

Work performed from the beginning of the project to the end of the period covered by the report and main results achieved so far

In one working/discussion paper, we aim to understand how electronic trading platforms reduce search costs. We show that traders adopt electronic platforms in order to connect to new dealers in the bilateral market. But ones they are connected, traders exit the platform and rather continue trading in the bilateral market. A key issue is that adoption times are not random, so we make use of econometric techniques to generate quasi-randomness. An implication of our findings is that evaluating the impact of an electronic trading platform solely through its market share underestimates its role. These platforms serve as crucial infrastructure for network formation, reshaping OTC trading relationships and market dynamics in ways that are not immediately captured by conventional market share metrics.

In another working/discussion paper, we find that illiquid bonds arise due to a firm-supply channel. Firms issue illiquid assets in expectation of future deleveraging needs. The offering of illiquid assets predicts firms' future deleveraging activity, which happens through repurchasing illiquid assets. We establish our findings within a stringent empirical setup where we exploit variation in repurchasing activity within firms. Our analysis challenges the idea that illiquid assets are mainly a symptom of market frictions and shows that they are driven by corporate demand for financial flexibility

Progress beyond the state of the art and expected potential impact (including the socio-economic impact and the wider societal implications of the project so far)

An important impact could be to document why electronic trading platforms do not replace traditional bilateral trading—a fact considered as a puzzle. This happens because traders adopt the platform only for very specific transactions, that is, when they want to reduce search frictions and thus increase connections to traditional OTC dealers. After they have adopted the platform, and formed new connections, they exit the platform again and keep on trading bilaterally—their total transaction volume in the bilateral market even increases. In this way, the total market share of electronic trading platforms remains low, simply because traders exit quickly.