Coordination and Fragility in Liquidity Provision

We study liquidity provision by dealers in a dynamic model of asset markets. When economic fundamentals are high (low), dealers provide more (less) liquidity by holding more (less) inventory, the market is liquid (illiquid), and interdealer trading is active (inactive). When fundamentals are medium, a dealer provides more liquidity if and only if other dealers do so, leading to coordination motives and multiple equilibria. Switching between equilibria implies liquidity jumps and volatility, providing an explanation for the unprecedentedly large disruptions in Treasury and corporate bond markets during the COVID-19 crisis and the subsequently quick liquidity improvement after the Fed announcements