A Welfare Analysis of Fragmented Liquidity Markets

Leveraged investors may be subject to contagion when sales of repossessed collateral create a downward spiral in fire sales prices, increasing margin requirements and drying up the supply of liquidity. This raises the question whether market integration is desirable when the risk of contagion is significant. While a policy that erects barriers to the free flow of liquidity across countries (fragmentation) can mitigate the incidence of contagion, it creates another problem: Liquidity may remain idle in one country while its neighbour suffers a financial crisis. We conduct a welfare analysis to net out the two effects. We show that, by itself, fragmentation has a negative welfare effect: It can only fend off mild financial crises, at the cost of exposing the country to more severe ones. At the same time, since liquidity is under-provided in a competitive equilibrium, governments should inject more of it, which could involve fragmentation, in some cases. Nevertheless, in the absence of coordination, governments are likely to fragment over and above the social optimum. Such sub-optimal fragmentation is particularly likely when governments become massive suppliers of liquidity. It follows that the recent increase in fragmentation may reflect the implementation of beggar-thy-neighbour policies rather than the proper treatment of market failures.