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LIQUIDITY PROVISION IN CAPACITY-CONSTRAINED MARKETS

Published online by Cambridge University Press:  13 April 2011

Pierre-Olivier Weill
Pierre-Olivier Weill*
Affiliation:
University of California, Los Angeles and National Bureau of Economic Research
*
Address correspondence to: Pierre-Olivier Weill, 8283 Bunche Hall, Department of Economics, University of California, Los Angeles, Los Angeles, CA 90095, USA; e-mail: poweill@econ.ucla.edu.
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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.

Keywords

Market Makers Inventory ManagementSearchTime-Varying Bid–Ask Spread
Type
Articles
Information
Macroeconomic Dynamics , Volume 15 , Supplement S1: Money, Credit, and Liquidity: Part 1 , April 2011 , pp. 119 - 144
Copyright
Copyright © Cambridge University Press 2011

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