Market-making with Search and Information Frictions

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

No 18-20, Working Papers from Federal Reserve Bank of Philadelphia

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.

Keywords: Adverse selection; trading frictions; bid-ask spreads; liquidity; learning (search for similar items in EconPapers)
Pages: 54 pages
Date: 2018-07-19
New Economics Papers: this item is included in nep-mst
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Citations: View citations in EconPapers (5)

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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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