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 providing 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.