Liquidity in Asset Markets with Search Frictions∗

We develop a search-theoretic model of financial intermediation and use it to study how trading frictions affect the distribution of asset holdings, asset prices, efficiency, and standard measures of liquidity. A distinctive feature of our theory is that it allows for unrestricted asset holdings, so market participants can accommodate trading frictions by adjusting their asset positions. We show that these individual responses of asset demands constitute a fundamental feature of illiquid markets: they are a key determinant of bid-ask spreads, trade volume, and trading delays–all the dimensions of market liquidity that search-based theories seek to explain. ∗We are grateful to Gadi Barlevy, Darrell Duffie, Mariacristina De Nardi, Nicolae Gârleanu, Joe Haubrich, Rob Shimer, Neil Wallace, Pierre-Olivier Weill, and Ruilin Zhou for comments. We also thank seminar participants at the Bank of Portugal, Chicago GSB, Federal Reserve Bank of Cleveland, Federal Reserve Bank of New York, Indiana, HEC Lausanne, London Business School, Penn State, Princeton, Queens, Rice, Simon Fraser, Singapore Management University, Universidad Torcuato Di Tella, University of Basel, UCLA, UCSB, University of Pennsylvania, and University of Texas at Austin. We thank Patrick Higgins for research assistance. Financial support from the C. V. Starr Center for Applied Economics at NYU is gratefully acknowledged. The views expressed herein are those of the authors and not necessarily those of the Federal Reserve Bank of Cleveland, the Federal Reserve Bank of Minneapolis, or the Federal Reserve System.