Endogenous Liquidity and Contagion

Market liquidity is typically characterized by a number of ad hoc metrics, such as depth, volume, bid-ask spreads 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 characterize its relationship to the usual proxies. Our analysis rests on a general equilibrium model with multiple assets and restricted investor participation. Strategic intermediaries pursue profit opportunities by provid- ing intermediation services (i.e. “liquidity”) in exchange for an endogenous fee. Our model is well-suited to study the contagion-like effects of liquidity shocks.

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