48 Pages Posted: 17 May 2017
Date Written: November 2016
We show that limited dealer participation in the market, coupled with an informational friction resulting from high frequency trading, can induce demand for liquidity to be upward sloping and strategic complementarities in traders' liquidity consumption decisions: traders demand more liquidity when the market becomes less liquid, which in turn makes the market more illiquid, fostering the initial demand hike. This can generate market instability, where an initial dearth of liquidity degenerates into a liquidity rout (as in a flash crash). While in a transparent market, liquidity is increasing in the proportion of high frequency traders, in an opaque market strategic complementarities can make liquidity U-shaped in this proportion as well as in the degree of transparency.
Keywords: market fragmentation; high frequency trading; flash crash; asymmetric information
JEL Classification: G10, G12, G14
Suggested Citation: Suggested Citation
Cespa, Giovanni and Vives, Xavier, High Frequency Trading and Fragility (November 2016). IESE Business School Working Paper No. 1161-E. Available at SSRN: https://ssrn.com/abstract=2969739 or http://dx.doi.org/10.2139/ssrn.2969739