Staff Reports
Liquidity and Congestion
October 2008 Number 349
Revised November 2010
JEL classification: G12, D40

Author: Gara M. Afonso

This paper studies the relationship between the endogenous arrival of investors to a market and liquidity in a search-based model of asset trading. Entry of investors causes two contradictory effects. First, it reduces trading costs, which attracts new investors (the externality effect). But second, as investors concentrate on one side of the market, the market becomes “congested,” decreasing the returns to investing and discouraging new investors from entering (the congestion effect). The equilibrium level of liquidity depends on which of the two effects dominates. When congestion is the leading effect, some interesting results arise. In particular, diminishing trading costs can deteriorate liquidity and welfare.

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For a published version of this report, see Gara M. Afonso, "Liquidity and Congestion," Journal of Financial Intermediation 20, no. 3 (July 2011): 324-60.