A Theory of Strategic Intermediation and Endogenous Liquidity

Abstract

Market liquidity is typically characterised 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 characterise its relationships with the usual proxies. The model on which the welfare analysis rests is an equilibrium model with multiple assets and with 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 transmission effects of liquidity shocks. We also consider the case when intermediaries can optimally design securities.

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

JEL Classification: G18, G20, D81