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Market fragmentation and contagion

Rahi, Rohit ORCID: 0000-0001-6887-9160 and Zigrand, Jean-Pierre ORCID: 0000-0002-7784-4231 (2020) Market fragmentation and contagion. Systemic Risk Centre Discussion Papers (102). Systemic Risk Centre, The London School of Economics and Political Science, London, UK.

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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 intermediating trades between venues. The welfare impact on venue k of a liquidity shock on venue l can go in either direction, depending on whether intermediated 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 intermediation, 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.

Item Type: Monograph (Discussion Paper)
Official URL:
Additional Information: © 2020 The Author(s)
Divisions: Finance
Subjects: H Social Sciences > HC Economic History and Conditions
H Social Sciences > HG Finance
JEL classification: G - Financial Economics > G1 - General Financial Markets > G10 - General
G - Financial Economics > G2 - Financial Institutions and Services > G20 - General
D - Microeconomics > D5 - General Equilibrium and Disequilibrium > D52 - Incomplete Markets
D - Microeconomics > D5 - General Equilibrium and Disequilibrium > D53 - Financial Markets
Date Deposited: 05 Jun 2023 14:39
Last Modified: 16 Sep 2023 00:00

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