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Liquidity Provision In Capacity-Constrained Markets

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  • Weill, Pierre-Olivier

Abstract

We study a competitive dynamic financial market subject to a transient selling pressure when market makers face a capacity constraint on their number of trades per unit of time with outside investors. We show that profit-maximizing market makers provide liquidity in order to manage their trading capacity constraint optimally over time: they use slack trading capacity early to accumulate assets when the selling pressure is strong in order to relax their trading capacity constraint and sell to buyers more quickly when the selling pressure subsides. When the trading capacity constraint binds, the bid–ask spread is strictly positive, widening and narrowing as market makers build up and unwind their inventories. Because the equilibrium asset allocation is constrained Pareto-optimal, the time variations in bid–ask spread are not a symptom of inefficient liquidity provision.

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  • Weill, Pierre-Olivier, 2011. "Liquidity Provision In Capacity-Constrained Markets," Macroeconomic Dynamics, Cambridge University Press, vol. 15(S1), pages 119-144, April.
    • Handle: RePEc:cup:macdyn:v:15:y:2011:i:s1:p:119-144_00
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    Cited by:

    1. Cyril Monnet & Francesca Carapella, 2013. "Dealers' Insurance, Market Structure And Liquidity," 2013 Meeting Papers 1144, Society for Economic Dynamics.
    2. Guillaume Rocheteau & Pierre‐Olivier Weill, 2011. "Liquidity in Frictional Asset Markets," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 43(s2), pages 261-282, October.
    3. Pierre-Olivier Weill, 2020. "The search theory of OTC markets," NBER Working Papers 27354, National Bureau of Economic Research, Inc.
    4. Athanasios Geromichalos & Kuk Mo Jung, 2014. "An Over-the-Counter Approach to the FOREX Market," Working Papers 156, University of California, Davis, Department of Economics.
    5. Carapella, Francesca & Monnet, Cyril, 2020. "Dealers’ insurance, market structure, and liquidity," Journal of Financial Economics, Elsevier, vol. 138(3), pages 725-753.

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