By Dave DeFusco
When most people think about financial crises, they picture crashing stock prices or headlines about banks failing. But some of the most important problems during a crisis actually happen in places most people never see, like in over-the-counter (OTC) markets where many bonds and other financial products are traded quietly through middlemen called dealers.
A working paper by Dr. Assa Cohen, program director of the M.S. in Finance at ӣ’s Sy Syms School of Business, argues that these hidden markets freeze up in crises not only because dealers are under financial strain, but because of something more subtle and troubling: dealers take advantage of their temporary power over stressed customers.
The paper, “Why We Should Start Thinking of Illiquidity Spells in Over-the-Counter Markets in Terms of Oligopolistic Inefficiency,” was presented at the Southern Finance Association Conference and reframes how we understand the sudden, painful slowdown in OTC trading that happens during events, like the 2008 financial crisis or the March 2020 COVID-19 market panic. In short, Cohen finds that OTC markets often become inefficient because dealers strategically choose not to help.
OTC markets are very different from the stock market. There’s no central exchange like the New York Stock Exchange where prices are posted publicly. Instead, buyers and sellers have to go through dealers, who connect the two sides and set the trading price. That gives dealers a lot of power, especially when markets become stressed.
During a crisis, many investors urgently want to sell their bonds. In a stock market, other buyers can immediately step in but in OTC markets, investors usually have to sell only to a dealer. Further, as Cohen documents in the paper, high levels of segmentation and concentration exist in these markets, implying that in fact investors face very few dealers who are willing to trade each specific bond. This creates a situation where some dealers behave like near-monopolies. Cohen argues that in these moments, dealers widen the “spread”—the difference between what they pay and what they charge—not because their own costs go up, but because they can exploit customer panic.
“Two things motivated me,” said Cohen. “First, researchers had long suggested that bid-ask spreads had a large markup component, but did not give an explicit theory as to how dealers gain pricing power and what appeared like a highly competitive market. Second, there was a contrast in how spreads were measured and how they were interpreted. If spreads were widening because dealers were rolling over higher holding cost to their customers, as some suggested, then we shouldn’t see such big differences between the dealer-to-dealer price and the customer-to-dealer price. But we do and that’s a sign of markups, not balance-sheet cost.”
Using a special version of the TRACE database that shows which dealers traded which bonds, Cohen found that during a crisis, the difference between the prices dealers charge each other and the prices they charge regular customers almost doubles. That’s a strong sign that dealers are raising their markups—not just covering higher costs—when markets are under stress.
One of the paper’s most surprising findings is the remarkable concentration of OTC trading once the focus shifts to individual bonds. “At the market level, it looks like there are many dealers,” said Cohen, “but at the level of any single bond, only a few dealers account for almost all the trade.”
Past research gave the segmented nature of the market less attention, perhaps because the more commonly used version of TRACE, called Enhanced TRACE, doesn’t include dealer identities. Without knowing who traded, it looked like the market was competitive. With the fuller dataset, however, Cohen shows that the median bond has an effective concentration level similar to three equal-sized firms controlling its entire trading volume.
“Dealers specialize,” said Cohen. “They know certain issuers and certain industries well. Other dealers are hesitant to simply step in, especially during a crisis.”
Cohen identifies three forces that push dealers to increase markups and cut back trading during crises: First, customers become desperate to sell, and dealers exploit it to buy securities for steep discounts. During a financial crisis, trading in certain markets often slows. Cohen explains that this slowdown can also happen because the middlemen who connect buyers and sellers, called broker-dealers, have more power during stressful times. When that happens, they may charge higher markups; because higher prices drive away some trades, the total amount of trading drops.
Cohen said this suggests that the drop in trading in over-the-counter markets during a crisis resembles the kind of harm most economists associate with monopoly power. “A monopoly has to balance how much it marks up prices against how much it sells, and that balance often leads to under-production,” he said. “Broker-dealers face a similar tradeoff which results in less intermediation and, hence, less trade. The inefficiency of a monopoly becomes worse when customers demand is less responsive to changes in the prices, what economists refer to as ‘low elasticity.’ That is exactly what happens in OTC markets during a crisis, with some customers willing to take large losses just to turn their bonds into cash.”
Second, during a crisis, the risk of buying a “lemon” rises. When risk increases across the economy, dealers become more afraid of buying something they don’t fully understand. Uninformed dealers retreat, leaving only the informed ones who now face much less competition.
Third, some dealers hit capacity limits, which further limits the competition. This is the traditional explanation, but Cohen finds it unnecessary to explain the crisis patterns. Even if dealer capacity had stayed the same in March 2020, liquidity still would have been badly diminished due to dealers’ exercising their market power more aggressively. Cohen believes it implies that policy tools injecting further liquidity into the dealer sector during a crisis, such as the Federal Reserve’s Primary Dealer Credit Facility, are not sufficient for restoring liquidity.
“Funding helps with lowering holding costs that get transmitted into higher spreads,” he said, “but it falls short of alleviating the decline in liquidity due to the rise in dealers’ market power. In other words, you can give dealers the cash, but you can’t force them to compete.”
Cohen’s paper argues that OTC markets are fragile not just because they rely heavily on the health of the dealer-to-dealer network. Their structure—fragmented and highly specialized—also limits competition. Instead of being able to sell to any interested buyer, investors often end up with only a handful of dealers who actually trade their specific bonds. That narrow set of trading partners is what makes trade in this market especially vulnerable to being impeded by monopolistic behavior when stress hits.
By highlighting this dynamic, Cohen urges regulators and policymakers to view OTC market crises not as accidents of funding shortages but as predictable outcomes of market design. “Intermediaries don’t just become weak in crises,” said Cohen. “They can also become powerful, and that power can severely limit liquidity when it’s needed most.”
