Illiquidity Contagion and Liquidity Crashes∗
نویسندگان
چکیده
Liquidity providers in a security often use prices of other securities as a source of information to set their quotes. As a result, liquidity is higher when prices are more informative. In turn, prices are more informative when liquidity is higher. We show that this self-reinforcing relationship between price informativeness and liquidity is a source of contagion and fragility: a small drop in the liquidity of one security propagates to other securities and can, through a feedback loop, result in a large drop in market liquidity. Furthermore, this relationship also generates multiple equilibria characterized either by high illiquidity and low price informativess or low illiquidity and high price informativeness. A switch from the latter to the former type of equilibrium generates a liquidity crash. We use the model to interpret the Flash Crash of May 6, 2010.
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