Working Papers

We model asset issuance in over-the-counter markets. Investors buy newly issued assets in a primary market and trade existing assets in a secondary market, where trade in both markets is over-the-counter (OTC). We show that the level of asset issuance and its efficiency depend on how investors split the surplus in secondary market trade. If buyers get most of the surplus, then sellers do not have incentives to participate in the primary market in order to intermediate assets and the economy has a low level of assets. On the other hand, if sellers get most of the surplus, buyers have strong incentives to participate in the primary market and the economy has a high level of assets. The decentralized equilibrium is inefficient for any splitting rule. The result follows from a double-sided hold-up problem in which it is impossible for all investors to take into account the full social value of an asset when trading. We propose a tax/subsidy scheme and show how it restores efficiency. We also extend the model in several dimensions and study the robustness of the inefficiency result. Finally, we explore the effects of the inefficiency using numerical examples. We study how bargaining power and trading speed in the secondary market affect the efficiency result, and we notice some interesting implications for policy interventions aimed to restore efficiency to OTC markets.