Liquidity is generally regarded to be of critical importance to the stability and efficiency of financial markets. Indeed, the lack of it is often blamed for exacerbating the price deterioration during market crises such as the 1987 stock market crash, the 1998 near collapse of the hedge fund Long Term Capital Management (LTCM), and the 2007 upheaval in the credit market. Yet there is little consensus about what exactly liquidity is, what determines it, and how it affects asset prices and welfare. Views become even more divergent when it comes to appropriate policies with respect to market liquidity, such as lowering barriers of entry in securities trading, setting margin and capital requirements for broker-dealers, coordinating market participants, and supplying liquidity during crises. The ongoing debate on the interventions by the central banks and U.S. Treasury to inject liquidity into the market in response to the current credit market crisis is an excellent case in point. The purpose of this paper is to present a simple theoretical framework to facilitate discussions on these issues.
In particular, we present an equilibrium model of liquidity demand and supply. We show that when constant market presence is costly, potential buyers and sellers with matching trading needs fail to coordinate their trades, giving rise to endogenous order imbalances and the demand for liquidity. The same cost also hinders the supply of liquidity. As a result, purely idiosyncratic shocks can cause large deviations in prices from fundamentals. Moreover, we show that market forces generally fail to supply sufficient liquidity, suggesting the need for policy interventions. We emphasize, however, that not all policy interventions are created equal—different interventions can lead to divergent consequences. For example, a direct injection of liquidity, even when it is in obvious shortage, can actually reduce welfare, while forced supply of liquidity by market participants, even though they individually find it suboptimal, can sometimes improve welfare. Furthermore, we show that the welfare consequences of the same policy interventions can vary significantly depending on the structure of the market.
To model the need for and provision of liquidity in a unified framework, we start with an economy in which agents face both idiosyncratic and aggregate risks. It is the need to share the idiosyncratic risks that gives rise to agents’ need to trade in the asset market. By definition, idiosyncratic risks sum to zero across all agents. Thus, underlying trading needs are always perfectly matched among agents.
We show that these perfectly matched trading needs can lead to aggregate liquidity demand under costly participation. In particular, when market presence is costless, all agents stay in the market at all times. The market price adjusts to coordinate all buyers and sellers, that is, buy and sell orders, which are driven by idiosyncratic risks, are always in balance. Further, asset prices are fully determined by the fundamentals, that is, the level of aggregate risk, and are independent of agents’ idiosyncratic trading needs. However, actual markets do not function in this “gigantic town meeting” style, as Grossman and Miller (1988) call it. Costs prevent potential buyers and sellers from constantly participating in the market. Thus, at any given instant, only a subset of traders are present. As they trade only infrequently, traders are forced to bear certain idiosyncratic risks. This extra risk makes them less risk tolerant and less willing to hold their share of the aggregate risk. Traders receiving additional idiosyncratic risk in the same direction as the aggregate risk are farther away from their desired position and thus are more eager to trade. Consequently, more of them enter the market than those with idiosyncratic risk in the opposite direction (which partially offsets their exposure to the aggregate risk). Thus, despite perfectly matching trading needs, traders fail to synchronize their trades, leading to aggregate order imbalances and the demand for liquidity.
The endogenous liquidity demand leads to profitable opportunities and therefore induces the supply of liquidity. We show that the same costs that lead to the demand for liquidity also limit the supply of liquidity in the market. To capture these costs in a way that is consistent with the observed market structure, we assume that an agent can incur an ex ante cost to be a “market maker” and then trade constantly to supply liquidity, or can remain a “trader” and pay a spot cost to trade (and consume liquidity) only if his ex post trading needs call for doing so. The market makers in our model include all agents that maintain a constant market presence—e.g., dealers, trading desks, and hedge funds—while the traders comprise the agents that only enter the market when they need to trade—e.g., the majority of individual and some institutional investors. In this context, the cost of market presence captures not only the cost of being in the market and staying ready to trade, but also the cost of raising needed capital, in other words, any costs or hurdles that prevent the free flow of capital into the market.
