Market-Making with Search and Private Information

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

No 1554, 2017 Meeting Papers from Society for Economic Dynamics

Abstract: We study a dynamic financial market where informed traders meet and trade with marketmakers in bilateral interactions. In such an environment, market liquidity, summarized by the bid-ask spread, is determined jointly by the two primitive forces, namely search frictions (as in Duffie et. al., 2005) and asymmetric information (in the spirit of Glosten and Milgrom, 1985). We show that their interaction leads to novel and perhaps surprising implications, both positive and normative. Reducing trading frictions, for example, leads to a decline in the speed of learning from market-wide activities. This in turn exacerbates the effects of asymmetric information, which can lead to lower liquidity and welfare. On the other hand, more transparency increases the distortions from market-power and also has negative liquidity/welfare consequences. Finally, we devise an empirical strategy to disentangle the significance of each friction from observable data on trades. Our results point to the value of a unified framework with both frictions for evaluating the effects of policies.

Date: 2017
New Economics Papers: this item is included in nep-mst
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