Working Paper: NBER ID: w24648
Authors: Benjamin Lester; Ali Shourideh; Venky Venkateswaran; Ariel Zetlin-Jones
Abstract: We develop a dynamic model of trading through market-makers that incorporates two canonical sources of illiquidity: trading (or search) frictions, which imply that market-makers have some amount of market power; and information frictions, which imply that market-makers face some degree of adverse selection. We use this model to study the effects of various technological innovations and regulatory initiatives that have reduced trading frictions in over-the-counter markets. Our main result is that reducing trading frictions can lead to less liquidity, as measured by bid-ask spreads. The key insight is that more frequent trading—or more competition among dealers—makes traders’ behavior less dependent on asset quality. As a result, dealers learn about asset quality more slowly and set wider bid-ask spreads to compensate for this increase in uncertainty.
Keywords: Marketmaking; Search Frictions; Information Frictions; Market Liquidity
JEL Codes: D82; D83; G14
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| reducing trading frictions (F12) | tighter bid-ask spreads (G19) |
| increased competition among dealers (D43) | tighter bid-ask spreads (G19) |
| slower learning about asset quality (G21) | wider bid-ask spreads (G19) |
| reducing trading frictions (F12) | slower learning about asset quality (G21) |
| reducing trading frictions (F12) | wider bid-ask spreads (G19) |