Market Fragmentation and Contagion

30 Pages Posted: 22 Sep 2020

See all articles by Rohit Rahi

Rohit Rahi

London School of Economics - Department of Finance; London School of Economics & Political Science (LSE) - Financial Markets Group

Jean-Pierre Zigrand

London School of Economics - Department of Finance, Systemic Risk Centre, and Financial Markets Group

Date Written: August 7, 2020

Abstract

We study the transmission of liquidity shocks from one sector of the economy to other sectors in a general equilibrium model with multiple trading venues connected by profit-seeking arbitrageurs. Arbitrageurs effectively provide liquidity to investors by inter-mediating trades between venues. The welfare impact on venue k of a liquidity shock on venue l can go in either direction, depending on whether inter-mediated trades on k behave as complements or substitutes for such trades on l. In addition to this direct effect through the arbitrage network, there is a feedback effect of an adverse shock reducing liquidity and arbitrageur profits, which leads to a lower level of inter-mediation, further reducing liquidity. We illustrate this contagion with examples of high-frequency trading in equity markets, shocks to one tranche of a collateralized debt obligation impacting investors in the other tranches, carry trade crashes, shocks to cross-country bank lending following the global financial crisis, and the bursting of the Japanese bubble in the early 1990s.

Keywords: market fragmentation, inter-mediation, arbitrage, liquidity shocks, contagion

JEL Classification: G10, G20, D52, D53

Suggested Citation

Rahi, Rohit and Zigrand, Jean-Pierre, Market Fragmentation and Contagion (August 7, 2020). Available at SSRN: https://ssrn.com/abstract=3669354 or http://dx.doi.org/10.2139/ssrn.3669354

Rohit Rahi (Contact Author)

London School of Economics - Department of Finance ( email )

Houghton Street
London, WC2A 2AE
United Kingdom
+44 20 7955 7313 (Phone)

HOME PAGE: http://https://sites.google.com/lse.ac.uk/rohit-rahi

London School of Economics & Political Science (LSE) - Financial Markets Group ( email )

Houghton Street
London WC2A 2AE
United Kingdom

Jean-Pierre Zigrand

London School of Economics - Department of Finance, Systemic Risk Centre, and Financial Markets Group ( email )

Houghton Street
London WC2A 2AE
United Kingdom
+44 20 7955 6201 (Phone)
+44 20 7955 7420 (Fax)

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