Liquidity Creation and Financial Stability: The Role of Hidden Trades

Abstract

This paper studies liquidity insurance by financial intermediaries when agents can make unobservable side trades. Closed-end mutual funds of Jacklin (1987) achieve constrained efficiency when regulated appropriately, equilibrium is unique, and there are no financial panics. In an economy with banks funded by demand deposits, financial panics also do not arise when banks and depositors can trade in a credit market. These results highlight the central role played by trading possibilities in shaping liquidity creation and financial stability.

Keywords: Liquidity creation, liquidity insurance, hidden trades, bank runs, financial stability

JEL Classification: D91, E61, G21, G23, G28