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Pecuniary Externalities, Segregated Exchanges, and Market Liquidity in a Diamond-Dybvig Economy with Retrade

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  • Borys Grochulski

Abstract

Pecuniary externalities often serve as a rationale for government intervention into financial markets. This article reviews the theory of market provision of liquidity in a Diamond-Dybvig economy and examines whether or not the possibility of retrade leads to pecuniary externalities and market failure. The answer hinges on the credibility of market participants' commitment to not enter into hidden transactions with non-participants. If such commitment is not credible, then unrestricted, hidden retrade leads to a pecuniary externality and market under-provision of liquidity. If such commitment is credible, retrade can be restricted to segregated exchanges with entry fees internalizing the impact of individual decisions on retrade prices, thus eliminating the pecuniary externality and ensuring efficient provision of liquidity in competitive equilibrium.

Suggested Citation

  • Borys Grochulski, 2013. "Pecuniary Externalities, Segregated Exchanges, and Market Liquidity in a Diamond-Dybvig Economy with Retrade," Economic Quarterly, Federal Reserve Bank of Richmond, issue 4Q, pages 305-340.
    • Handle: RePEc:fip:fedreq:00010
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    Cited by:

    1. Park, Jaevin, 2023. "Rights to retrade, free-riding and insurance requirement," Economics Letters, Elsevier, vol. 225(C).
    2. di Iasio, Giovanni & Kryczka, Dominika, 2021. "Market failures in market-based finance," Working Paper Series 2545, European Central Bank.

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