DP11732 Market Transparency and Fragility

Author(s): Giovanni Cespa, Xavier Vives
Publication Date: December 2016
Date Revised: June 2019
Keyword(s): asymmetric information, flash crash, liquidity fragility, market fragmentation
JEL(s): G10, G12, G14
Programme Areas: Financial Economics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=11732

We show that dealers' limited market participation, coupled with an informational friction resulting from lack of market transparency, can make liquidity demand upward sloping, inducing strategic complementarities: traders demand more liquidity when the market becomes less liquid, fostering market illiquidity. This can generate instability with an initial dearth of liquidity degenerating into a liquidity rout (as in a flash crash). In a fully transparent market, liquidity is increasing in the proportion of dealers continuously present in the market; however, in a less transparent market, liquidity can be U-shaped in this proportion and in the degree of transparency.