Liquidity in Competitive Dealer Markets

Abstract

We study a continuous-time version of the intermediation model of Grossman and Miller [18]. To wit, we solve for the competitive equilibrium prices at which liquidity takers' demands are absorbed by dealers with quadratic inventory costs, who can in turn gradually transfer these positions to an end-user market. This endogenously leads to a model with transient price impact.Smooth, diffusive, and discrete trades all incur finite but nontrivial liquidity costs, and can arise naturally from the liquidity takers' optimization.Mathematics Subject Classification: (2010) 91B26, 91B24, 91B51.JEL Classification: C68, D43, G12.