A Theory of Strategic Intermediation and Endogenous Liquidity

32 Pages Posted: 14 Nov 2007 Last revised: 6 Jan 2008

See all articles by Rohit Rahi

Rohit Rahi

London School of Economics - Department of Finance; London School of Economics & Political Science (LSE) - Financial Markets Group

Jean-Pierre Zigrand

London School of Economics - Department of Finance, Systemic Risk Centre, and Financial Markets Group

Date Written: December 17, 2007

Abstract

Market liquidity is typically characterized by a number of ad hoc metrics, such as depth (or market impact), volume, intermediation costs (such as breadth) etc. No general coherent definition seems to exist, and few attempts have been made to justify the existing metrics on welfare grounds. In this paper we propose a welfare-based definition of liquidity and characterize its relationship with the usual proxies. The model on which the welfare analysis rests is an equilibrium model with multiple assets and restricted investor participation. Strategic intermediaries pursue profit opportunities by providing intermediation services (i.e. liquidity) in exchange for an endogenous fee. Our model is well suited to study the contagion-like effects of liquidity shocks. We also consider the case in which intermediaries can optimally design securities.

Keywords: Liquidity, intermediation, arbitrage, restricted participation, contagion, market microstructure

JEL Classification: G10, G20, D52, D53

Suggested Citation

Rahi, Rohit and Zigrand, Jean-Pierre, A Theory of Strategic Intermediation and Endogenous Liquidity (December 17, 2007). Available at SSRN: https://ssrn.com/abstract=1029400 or http://dx.doi.org/10.2139/ssrn.1029400

Rohit Rahi (Contact Author)

London School of Economics - Department of Finance ( email )

Houghton Street
London, WC2A 2AE
United Kingdom
+44 20 7955 7313 (Phone)
+44 20 7955 7420 (Fax)

HOME PAGE: http://vishnu.lse.ac.uk/

London School of Economics & Political Science (LSE) - Financial Markets Group ( email )

Houghton Street
London WC2A 2AE
United Kingdom

Jean-Pierre Zigrand

London School of Economics - Department of Finance, Systemic Risk Centre, and Financial Markets Group ( email )

Houghton Street
London WC2A 2AE
United Kingdom
+44 20 7955 6201 (Phone)
+44 20 7955 7420 (Fax)

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