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Trading Frictions in Dynamic Cap-and-Trade Markets

Author

Listed:
  • Nicola Borri
  • Yukun Liu
  • Aleh Tsyvinski
  • Xi Wu

Abstract

We develop a dynamic stochastic model of markets with an externality and multiple trading frictions, and cap-and-trade as the leading application. Slow participation, limited intermediation, and heterogeneous information interact in equilibrium: agents choose costly market access, access determines residual compliance demand, intermediary constraints translate residual demand into a surrender-month premium, and the premium feeds back into access incentives. These interactions shape how effectively the market corrects the externality. We characterize access choices in closed form, prove that the equilibrium premium is unique, and show that endogenous access dampens the response to each friction in isolation, while the interaction of multiple frictions is non-additive and can amplify the price response. We quantify the model using 2.7 million EU ETS registry transactions and compliance records from 2005-2021. About 40% of operators do not trade annually, purchases concentrate in April when returns are systematically high, and operator flow predicts future returns.

Suggested Citation

  • Nicola Borri & Yukun Liu & Aleh Tsyvinski & Xi Wu, 2026. "Trading Frictions in Dynamic Cap-and-Trade Markets," Papers 2606.03767, arXiv.org, revised Jun 2026.
    • Handle: RePEc:arx:papers:2606.03767
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    References listed on IDEAS

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    1. Glosten, Lawrence R. & Milgrom, Paul R., 1985. "Bid, ask and transaction prices in a specialist market with heterogeneously informed traders," Journal of Financial Economics, Elsevier, vol. 14(1), pages 71-100, March.
    2. Rubin, Jonathan D., 1996. "A Model of Intertemporal Emission Trading, Banking, and Borrowing," Journal of Environmental Economics and Management, Elsevier, vol. 31(3), pages 269-286, November.
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    • H0 - Public Economics - - General

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