Market opacity and fragility: Why liquidity evaporates when it is most needed

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.