Liquidity in asset markets with search frictions

By Ricardo Lagos, Guillaume Rocheteau. 2007

184 citations recorded by the source corpus.

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.

Subfields: Economics and Econometrics, Finance

View Paper: https://www.semanticscholar.org/paper/c44c88ecffcba89a2d507d63391f986f2c0e0bfa

How researchers see this paper

The researchers whose trusted networks rank it highest, strongest advocate first. Every researcher gets a different order.

In Economics and Econometrics

1. Julien Hugonnier
2. Erwan Morellec
3. Semyon Malamud

In Finance

1. Julien Hugonnier
2. Erwan Morellec
3. Semyon Malamud
4. Gustavo Manso

Citations in the corpus

• Competing on Speed (2018, unknown): “(2) Following Lagos and Rocheteau (2009), we define the adjusted holding utility as ū (a; , ✏) ⌘ (r + ⇢) u ,✏ (a) + E [u ,✏ 0 (a) | ✏]”
• Capital Supply Uncertainty, Cash Holdings, and Investment (2014, background): “Duffie, Garleanu, and Perdersen, 2005, Vayanos and Weill, 2008, or Lagos and Rocheteau, 2010). Duffie (2009) provides an early survey of this literature.”
• The Same Bond at Different Prices: Identifying Search Frictions and Selling Pressures (2012, unknown): “Comparing rates on arguably liquid credit default swaps and less liquid corporate bonds, Longstaff, Mithal, and Neis (2005) find a significant non-default component. For example, the AAA 5-year non-default component is estimated to be 53 basis points. Similar evidence of a large non-default componen”
• Liquidity and asset-market dynamics (2010, unknown): “Lagos and Rocheteau (2009) analyze (dealers ) participation decisions but only look at steady states.”
• Adverse Selection and Liquidity Distortion (2011, unknown): “See, for example, Weill (2008), Lagos and Rocheteau (2009). 7Williamson and Wright (2008) provides a detailed survey of this line of literature.”
• Endogenous Liquidity and Defaultable Bonds (2012, unknown): “, Longstaff, Mithal, and Neis (2005), Beber, Brandt, and Kavajecz (2009), and Schwarz (2010)).”