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Liquidity in asset markets with search frictions

Ricardo Lagos,G. Rocheteau

Published 2007 in Econometrica

ABSTRACT

We study how trading frictions in asset markets affect the distribution of asset holdings, asset prices, efficiency, and standard measures of liquidity. To this end, we analyze the equilibrium and optimal allocations of a search-theoretic model of financial intermediation similar to Duffie, Gârleanu and Pedersen (2005). In contrast with the existing literature, the model we develop imposes no restrictions on asset holdings, so traders can accommodate frictions by varying their trading needs through changes in their asset positions. We find that this is a critical aspect of investor behavior in illiquid markets. A reduction in trading frictions leads to an increase in the dispersion of asset holdings and trade volume. Transaction costs and intermediaries’ incentives to make markets are nonmonotonic in trade frictions. With the entry of dealers, these nonmonotonicities give rise to an externality in liquidity provision that can lead to multiple equilibria. Tight spreads are correlated with large volume and short trading delays across equilibria. From a normative standpoint we show that the asset allocation across investors and the number of dealers are socially inefficient.

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