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Economic Quarterly

Fourth Quarter 2013

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

Borys Grochulski

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.

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