Intellectual Merit. The objective of this project is to study liquidity in fragmented financial markets, where trading and asset price formation occurs within subgroup of investors. The first part of the project, based on joint work with Bruno Biais, is a theoretical study of limit order trading. The largest equity and derivative markets around the world operate according to that model because it is thought to mitigate fragmentation and improve liquidity. Indeed, limit orders represent investors? trading need while they are absent from the market. This paper will be the first to study limit order trading in the search paradigm initiated by Duffie, Garleanu, and Pedersen (2005, 2007). The PI's will analyze how a theoretical limit order book responds to liquidity shocks, under the search assumption that investors can only submit and cancel orders infrequently. They will show how prices react and adjust; explain the dynamic of liquidity supply and demand and the corresponding evolution of the order book, trading volume, and transactions costs; describe investors' optimal trading strategies and the patterns of order submission that they generate. The proposal describes the basic framework, preliminary theoretical results and empirical implications that can be confronted to existing evidence. The PI's also propose additional directions of research, including a quantitative analysis and an extension of the model allowing a broader set of orders and contracts. The second part of the project is based on joint work. While most of the PI's research explains the impact of market fragmentation in specific market contexts, this proposal wants to adopt a macro perspective and study whether such frictions matter in the aggregate. To that end, the PI proposes a tractable consumption-based model with many fragmented financial markets that has simple and intuitive aggregate asset pricing implications. Equipped with this model, the proposal seeks to ask how a collection of possibly small fragmentation friction (such as search frictions) cumulates in the aggregate, and whether they add up to a quantitatively significant macro friction.
Broader Impact. The recent financial market turmoils and the subsequent macro economic disruptions highlight our need to better understand market liquidity, and liquidity-improving trading mechanisms. The project contributes to this agenda by providing coherent dynamic equilibrium models which are explicit about the trading frictions preventing unfettered participation in markets. The first model in this project will constitute a simple platform for studying the welfare impact of alternative market arrangements, as well as policy interventions. The second model is a first step in assessing the quantitative aggregate significance of the above mentioned trading frictions. The findings may be of independent interest to financial economists, macro-economists, and policy makers alike.
