Dealers' insurance, market structure, and liquidity

We develop a parsimonious model to study the equilibrium structure of financial markets and its efficiency properties. We find that regulations aimed at improving market outcomes can cause inefficiencies. The welfare benefit of such regulation stems from endogenously improving market access for some participants, thus boosting competition and lowering prices to the ultimate consumers. Higher competition, however, erodes profits from market activities. This has two effects: it disproportionately hurts more efficient market participants, who earn larger profits, and it reduces the incentives of all market participants to invest ex-ante in efficient technologies. The general equilibrium effect can therefore result in a welfare cost to society. Additionally, this economic mechanism can explain the resistance by some market participants to the introduction of specific regulation which could appear to be unambiguously beneficial