The Limits of Liquidity

Abstract

This article addresses key issues concerning liquidity provision in the context of two major functions of a marketplace: price discovery and quantity discovery. After first considering a perfectly liquid, frictionless environment, the authors turn to the real world—replete with trading costs, blockages, and other imperfections. The authors posit that illiquidity is in good part attributable to coordination difficulties involved in turning the orders of different agents into trades and transaction prices. An understanding of the coordination issue enables the authors to address the role that market structure plays in the production of liquidity. The article concludes with a big picture view of the limits of liquidity.