Discussion paper
DP11732 Market opacity and fragility: Why liquidity evaporates when it is most needed
We show that, consistent with empirical evidence, access to order flow information allows traders to supply liquidity via contrarian marketable orders. Lack of market transparency can make liquidity demand upward sloping, inducing strategic complementarity and multiple equilibria. Then an initial dearth of liquidity may degenerate into a liquidity rout (as in a “flash crash”) and traders faced with the largest cost of trading are those consuming more liquidity at equilibrium. An increase in order flow transparency and/or in the mass of dealers who are in the market at all times has a positive impact on total welfare.
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