Market Turmoil and Destabilizing Speculation

This paper explores how speculators can destabilize financial markets by amplifying negative shocks in periods of market turmoil, and confirms the main predictions of the theoretical analysis using data on money market funds (MMFs). I propose a dynamic trading model with two types of investors —long-term and speculative —who interact in a market with search frictions. During periods of turmoil created by an uncertainty shock, speculators react to declining asset prices by liquidating their holdings in hopes of buying them back later at a gain, despite the asset’s cash flows remaining the same throughout. Interestingly, I show that a reduction in search frictions leads to more severe fluctuations in asset prices. At the root of this result are the strategic complementarities between speculators expected to follow similar strategies in the future. Using a novel dataset on MMFs’portfolio holdings during the European debt crisis, I gauge the strength of funds’strategic interactions as the number of funding relationships each issuer has with MMFs. I show that funds are more likely to liquidate the securities of issuers that have fewer funding relationships with other funds, obliging them to borrow at shorter maturity and higher interest rates. ∗This paper is drawn from Chapter 1 of my PhD thesis at M.I.T. I am indebted to my advisors Daron Acemoglu, Abhijit Banerjee, Andrey Malenko and Stephen A. Ross for many long and fruitful discussions that greatly improved the paper, and for their constant encouragement. I also thank Efraim Benmelech, Jonathan Berk, Bruce Carlin, Hui Chen, Sergey Chernenko, Itamar Drechsler, Darrell Duffi e, Nicolae Gârleanu, Xavier Giroud, Robin Greenwood, Samuel G. Hanson, Raj Iyer, Victoria Ivashina, Leonid Kogan, Arvind Krishnamurthy, Matteo Maggiori, Roberto Marfe’, Konstantin Milbradt, Stefan Nagel, Marco Pagano, Dimitris Papanikolaou, Nicola Gennaioli, Francisco PérezGonzález, Zhiguo He, Joshua D. Rauh, Paola Sapienza, Alexi Savov, David S. Scharfstein, Philipp Schnabl, Antoinette Schoar, Amit Seru, Amir Sufi, Erik Stafford, Adi Sunderam, Stijn Van Nieuwerburgh, Pietro Veronesi, S. "Vish" Viswanathan, Ivan Werning and Luigi Zingales; as well as seminar participants at MIT, Columbia GSB, Stanford GSB, University of Chicago (Booth), Berkeley (Haas), HBS, Northwestern (Kellogg), Ohio State (Fisher College), NYU (Stern), Duke (Fuqua), UNC (Kenan-Flagler), BC (Carroll), New York Fed, Fed Board, Philly Fed, Collegio Carlo Alberto, EIEF, the European Finance Association meeting 2013, the Sixth Erasmus Liquidity conference for their insightful suggestions. I am grateful for the financial assistance of the George and Obie Shultz fund to acquire the data necessary for this project. Any errors are my own.