Discussion paper

DP11732 Market Transparency and Fragility

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.

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Citation

Vives, X and G Cespa (2016), ‘DP11732 Market Transparency and Fragility‘, CEPR Discussion Paper No. 11732. CEPR Press, Paris & London. https://cepr.org/publications/dp11732