Illiquidity Spirals in Coupled Over-the-Counter Markets

Banks provide intermediation of two economically coupled assets, each traded on an OTC market—e.g., secured debt and the underlying collateral. We model banks’ provision of liquidity as the outcome of a game of strategic complements on two coupled trading networks: a bank’s incentives to be active in one market are increasing in its neighbors’ activity in both markets. When an exogenous shock renders some banks inactive, other banks follow in an illiquidity spiral across the two networks. Liquidity can be improved if one of the two OTC markets is replaced by an exchange. For a class of market structures associated with random graphs, liquidity changes discontinuously in the size of an exogenous shock, in contrast to contagion on one network.