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  5. Market Opacity and Fragility: Why Liquidity Evaporates When It Is Most Needed

American Economic Review

ISSN 0002-8282 (Print) | ISSN 1944-7981 (Online)

Market Opacity and Fragility: Why Liquidity Evaporates When It Is Most Needed

  • Giovanni Cespa
  • Xavier Vives
American Economic Review (Forthcoming)

Abstract

Lack of market transparency can impair the liquidity provision of non-standard liquidity suppliers and make liquidity demand increasing in illiquidity. This can yield strategic complementarities and induce 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 trading more intensely 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. Keywords: Liquidity fragility, flash crash, strategic complementarity, order flow transparency.

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