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

Xavier Vives, Giovanni Cespa - Dec 04, 2023

Working Paper No.  00131-00

We show that, consistent with empirical evidence, access to order flow information allows traders to supply liquidity via contrarian marketable orders. Lack of market transparency can make liquidity demand upward sloping, inducing strategic complementarity and 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 consuming more liquidity 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.

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Liquidity fragility flash crash strategic complementarity order flow transparency.