Leaning Against the Wind
During financial disruptions, marketmakers provide liquidity by absorbing external selling pressure. They buy when the pressure is large, accumulate inventories, and sell when the pressure alleviates. This paper studies optimal dynamic liquidity provision in a theoretical market setting with large and temporary selling pressure, and order-execution delays. I show that competitive marketmakers offer the socially optimal amount of liquidity, provided they have access to sufficient capital. If raising capital is costly, this suggests a policy role for lenient central-bank lending during financial disruptions.
This paper was presented at the Optimal Design of Payments Systems Workshop in May of 2011.