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Federal Reserve Bank of Philadelphia
Working Papers
Market-making with Search and Information Frictions
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.


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Benjamin Lester & Ali Shourideh & Venky Venkateswaran & Ariel Zetlin-Jones, Market-making with Search and Information Frictions, Federal Reserve Bank of Philadelphia, Working Papers 18-20, 19 Jul 2018.
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Keywords: Adverse selection; trading frictions; bid-ask spreads; liquidity; learning
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