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Market fragmentation and contagion

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  • Rahi, Rohit
  • Zigrand, Jean-Pierre

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 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.

Suggested Citation

  • Rahi, Rohit & Zigrand, Jean-Pierre, 2020. "Market fragmentation and contagion," LSE Research Online Documents on Economics 118876, London School of Economics and Political Science, LSE Library.
    • Handle: RePEc:ehl:lserod:118876
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    File URL: http://eprints.lse.ac.uk/118876/
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    References listed on IDEAS

    as
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    More about this item

    Keywords

    market fragmentation; intermediation; arbitrage; liquidity shocks; contagion;
    All these keywords.

    JEL classification:

    • G10 - Financial Economics - - General Financial Markets - - - General (includes Measurement and Data)
    • G20 - Financial Economics - - Financial Institutions and Services - - - General
    • D52 - Microeconomics - - General Equilibrium and Disequilibrium - - - Incomplete Markets
    • D53 - Microeconomics - - General Equilibrium and Disequilibrium - - - Financial Markets

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