The Effect of Secondary Market Existence on Primary Market Liquidity: Theory and Evidence from a Natural Experiment in Peer-to-Peer Lending

Abstract

We develop a theoretical model of a primary market either with or without a secondary market for any type of risky security. We find that the existence of a secondary market increases primary market liquidity in the form of lower effective spreads and higher issuance quantities. The same underlying intuition suggests a shorter funding time as well. Next, we use the unexpected closure of Prosper’s secondary market to study how the existence of a secondary market affects primary market liquidity, as well as the spillover effect on the primary market liquidity of a prime competitor. Uniquely, our comprehensive intraday issuance data for the primary market allows us to precisely measure the liquidity of the primary market. We find that closure of Prosper’s secondary market reduces primary market liquidity on all three standard dimensions: time, cost, and quantity. Specifically, Prosper’s primary market liquidity is reduced because it takes longer to fund loans both by individuals and by institutions, requires a higher origination fee to fund loans by individuals, and decreases the percentage of loan listings that are funded by both individuals and institutions. Further, we find that closure of Prosper’s secondary market has a positive spillover effect on the primary market liquidity of its main competitor Lending Club by reducing its time to fund by individuals.

Keywords: Liquidity Premium, Secondary Market, Primary Market, P2P Lending

JEL Classification: G12, G23