Market-making with Search and Information Frictions

Benjamin Lester, Ali Shourideh, Venky Venkateswaran and Ariel Zetlin-Jones

No 24648, NBER Working Papers from National Bureau of Economic Research, Inc

Abstract: We develop a dynamic model of trading through market-makers that incorporates two canonical sources of illiquidity: trading (or search) frictions, which imply that market-makers have some amount of market power; and information frictions, which imply that market-makers face some degree of adverse selection. We use this model to study the effects of various technological innovations and regulatory initiatives that have reduced trading frictions in over-the-counter markets. Our main result is that reducing trading frictions can lead to less liquidity, as measured by bid-ask spreads. The key insight is that more frequent trading—or more competition among dealers—makes traders’ behavior less dependent on asset quality. As a result, dealers learn about asset quality more slowly and set wider bid-ask spreads to compensate for this increase in uncertainty.

JEL-codes: D82 D83 G14 (search for similar items in EconPapers)
Date: 2018-05
New Economics Papers: this item is included in nep-mst
Note: AP IFM
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Citations: View citations in EconPapers (9)

Published as Benjamin Lester & Ali Shourideh & Venky Venkateswaran & Ariel Zetlin-Jones, 2023. "Market-making with search and information frictions," Journal of Economic Theory, .

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Related works:
Journal Article: Market-making with search and information frictions (2023)
Working Paper: Market-making with Search and Information Frictions (2018)
Working Paper: Market-making with Search and Information Frictions (2018)
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