Liquidity in Competitive Dealer Markets

TL;DR

This paper models a continuous-time dealer market where liquidity costs and transient price impacts emerge endogenously from dealer inventory management and trade execution, providing insights into market liquidity dynamics.

Contribution

It introduces a continuous-time intermediation model with endogenous liquidity costs and transient price impacts, extending prior discrete models.

Findings

Liquidity costs are finite and depend on trade type.

Transient price impacts naturally arise from dealer inventory strategies.

Model captures realistic liquidity dynamics in dealer markets.

Abstract

We study a continuous-time version of the intermediation model of Grossman and Miller (1988). To wit, we solve for the competitive equilibrium prices at which liquidity takers' demands are absorbed by dealers with quadratic inventory costs, who can in turn gradually transfer these positions to an exogenous open market with finite liquidity. This endogenously leads to transient price impact in the dealer market. Smooth, diffusive, and discrete trades all incur finite but nontrivial liquidity costs, and can arise naturally from the liquidity takers' optimization.