Liquidity in asset markets with search frictions

We study how trading frictions in asset markets affect the distribution of asset holdings, asset prices, efficiency and standard measures of liquidity. To this end, we analyze the equilibrium and optimal allocations of a search-theoretic model of financial intermediation similar to Duffie, Gârleanu and Pedersen (2005). In contrast with the existing literature, the model we develop imposes no restrictions on asset holdings, so traders can accommodate frictions by varying their trading needs through changes in their asset postitions. We find that this is a critical aspect of investor behavior in illiquid markets. A reduction in trading frictions leads to an increase in the dispersion of asset holdings and trade volume. Trans-action costs and intermediaries ’ incentives to make markets are non-monotonic in trade frictions. With entry of dealers these non-monotonicities give rise to an externality in liq-uidity provision that can lead to multiple equilibria. Tight spreads are correlated with large volume and short trading delays across equilibria. From a normative standpoint we show that the asset allocation across investors and the number of dealers are socially inefficient