Inside and Outside Liquidity∗

We consider a model of liquidity demand arising from a possible maturity mismatch between asset revenues and consumption. This liquidity demand can be met with either cash reserves (inside liquidity) or via asset sales for cash (outside liquidity). The questions we address are: (a) what determines the mix of inside and outside liquidity in equilibrium? (b) does the market provide an efficient mix of inside and outside liquidity? and (c) if not, what kind of interventions can best restore efficiency? We argue that a key determinant of the optimal liquidity mix is the expected timing of asset sale decisions. An important source of inefficiency in our model is the presence of asymmetric information about asset values, which increases the longer a liquidity trade is delayed. We establish existence of an immediate-trading equilibrium, in which asset trading occurs in anticipation of a liquidity shock, and sometimes also of a delayed-trading equilibrium, in which assets are traded in response to a liquidity shock. We show that, when it exists, the delayed-trading equilibrium is efficient, despite the presence of adverse selection. ∗We thank Rafael Repullo and Lasse Pedersen as well as participants at workshops and seminars at several universities and at the 2008 NBER Summer Institute on Risks of Financial Institutions for their comments and suggestions.