DP8350 Learning from Prices, Liquidity Spillovers, and Market Segmentation

Author(s): Giovanni Cespa, Thierry Foucault
Publication Date: April 2011
Keyword(s): Colocation, Contagion, Liquidity Risk, Liquidity spillovers, Transparency, Value of price information
JEL(s): G10, G12, G14
Programme Areas: Financial Economics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=8350

We describe a new mechanism that explains the transmission of liquidity shocks from one security to another ("liquidity spillovers"). Dealers use prices of other securities as a source of information. As prices of less liquid securities convey less precise information, a drop in liquidity for one security raises the uncertainty for dealers in other securities, thereby affecting their liquidity. The direction of liquidity spillovers is positive if the fraction of dealers with price information on other securities is high enough. Otherwise liquidity spillovers can be negative. For some parameters, the value of price information increases with the number of dealers obtaining this information. In this case, related securities can appear segmented, even if the cost of price information is small.