Common Liquidity Risk and Market Collapse: Lessons from the Market for Perps

Abstract

We study the collapse of the market for perpetual floating rate notes (perps). The perp market was launched in 1984, and its first two years were characterized by explosive growth in which issues by high quality borrowers were placed with institutional investors and traded in liquid secondary markets. However, the perp market began collapsing precipitously in December 1986, due to the withdrawal of market intermediaries prompted by large order imbalances. Although most of the original perps remain outstanding, prices and liquidity have not recovered. We develop a model to explain the events observed in the perp market and to draw lessons on how commonality in liquidity can affect market performance and intermediary incentives. We provide new insights into how markets can collapse even in the absence of information asymmetry or bubbles. We also contribute to the corporate governance literature by providing a new rationale for placing securities with a broad investor base -- to minimize the possibility that common liquidity shocks will cause a market to fail.