M. Suresh Sundaresan

Public Provision of Private Liquidity: Evidence from the Millennium Date Change

Coauthor(s): Zhenyu Wang.

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Abstract:
The Millennium Date Change (often referred to as Y2K) was anticipated to be a major liquidity event by many financial and corporate institutions as well as the central banks around the world. The timing of the event was foreseeable and thus satisfies the assumptions in the economic theory on public provision of private liquidity. We apply the theory to understand the liquidity premium in financial markets and the actions of the U.S. central bank in the period surrounding Y2K. We demonstrate that in the presence of this potential aggregate liquidity shock, (1) the cost of private loans and insurance increased significantly, (2) government securities commanded a liquidity premium, and most importantly, (3) the Fed successfully provided liquidity insurance and reduced liquidity premium prior to Y2K by taking various actions and especially by issuing Y2K options. These results are consistent with the predictions of the economic theory. Our analysis links the behavior of on/off-the-run spread to the public provision of private liquidity.

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