Market Run-Ups, Market Freezes, Inventories, and Leverage∗

We study trade between a buyer and a seller when both may have existing inventories of assets similar to those being traded. We analyze how these inventories affect trade, information dissemination, and price formation. We show that when the buyer’s and seller’s initial leverage is moderate, inventories increase price and trade volume (a market “run up”), but when leverage is high, trade may become impossible (a market “freeze”). Our analysis predicts a pattern of trade in which prices and trade volume first increase, and then markets break down. Under many circumstances, the presence of competing buyers amplifies the increased-price effect. We use our model to discuss implications for regulatory intervention in illiquid markets. ∗We thank Jeremy Berkowitz, Mitchell Berlin, Alexander Bleck, Michal Kowalik, James Thompson, and Alexei Tchistyi, for their helpful comments. We also thank seminar participants at the Federal Reserve Bank of Philadelphia and conference participants at the AFA meeting, FIRS meeting, European Economic Association meetings, Eastern Finance Association meetings, and the Federal Reserve System Committee on Financial Structure and Regulation. An earlier draft circulated under the title “Why do markets freeze?” Any remaining errors are our own. The views expressed here are those of the authors and do not necessarily reflect those of the Federal Reserve Bank of Philadelphia or of the Federal Reserve System.