A Theory of Strategic Intermediation and Endogenous Liquidity

35 Pages Posted: 23 Jun 2004

See all articles by Jean-Pierre Zigrand

Jean-Pierre Zigrand

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

Date Written: March 16, 2004

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

Suggested Citation

Zigrand, Jean-Pierre, A Theory of Strategic Intermediation and Endogenous Liquidity (March 16, 2004). EFA 2004 Maastricht Meetings Paper No. 5330. Available at SSRN: https://ssrn.com/abstract=557077 or http://dx.doi.org/10.2139/ssrn.557077

Jean-Pierre Zigrand (Contact Author)

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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