We develop a search-theoretic model of financial intermediation and use it to study how trading frictions affect the distribution of asset holdings, asset prices, efficiency, and standard measures of liquidity. A distinctive feature of our theory is that it allows for unrestricted asset holdings, so market participants can accommodate trading frictions by adjusting their asset positions. We show that these individual responses of asset demands constitute a fundamental feature of illiquid markets: they are a key determinant of bid-ask spreads, trade volume, and trading delays—all the dimensions of market liquidity that search-based theories seek to explain.
This paper is an extension of Ricardo Lagos’s work while he was in the Research Department of the Federal Reserve Bank of Minneapolis.
Published In: Econometrica
(Vol. 77, No. 2, March 2009, pp. 403-426)
Download Paper (pdf)