Arbitrage with Financial Constraints and Market Power

Abstract

I study how financial constraints affect liquidity provision and welfare under different structures of the arbitrage industry. In competitive markets, financial constraints may impair arbitrageurs’ ability to provide liquidity, thereby reducing other investors’ welfare. Instead, in imperfectly competitive markets, I characterize situations in which imposing constraints on arbitrageurs leads to a Pareto improvement relative to a noconstraint case. Further, unlike the competitive case, a drop in arbitrage capital does not always lead to a reduction in market liquidity. A subtle interaction between financial constraints and arbitrageurs’ market power generates these Pareto improvment and novel comparative statics.