Liquidity Provision in Capacity Constrained Markets
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.
This paper was presented at the Optimal Design of Payments Systems Workshop in May of 2011.