Market Fragmentation and Contagion
30 Pages Posted: 22 Sep 2020
Date Written: August 7, 2020
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: Suggested Citation