Liquidity in Competitive Dealer Markets
26 Pages Posted: 8 Aug 2018
Date Written: July 22, 2018
We study a continuous-time version of the intermediation model of Grossman and Miller (1988). To wit, we solve for the competitive equilibrium prices at which liquidity takers' demands are absorbed by dealers with quadratic inventory costs, who can in turn gradually transfer these positions to an end-user market. This endogenously leads to a model with transient price impact. Smooth, diffusive, and discrete trades all incur finite but nontrivial liquidity costs, and can arise naturally from the liquidity takers' optimization.
Keywords: dealer market, dynamic equilibrium, endogenous liquidity
JEL Classification: C68, D43, G12
Suggested Citation: Suggested Citation