Working Paper: CEPR ID: DP8350
Authors: Giovanni Cespa; Thierry Foucault
Abstract: We describe a new mechanism that explains the transmission of liquidity shocks from one security to another ("liquidity spillovers"). Dealers use prices of other securities as a source of information. As prices of less liquid securities convey less precise information, a drop in liquidity for one security raises the uncertainty for dealers in other securities, thereby affecting their liquidity. The direction of liquidity spillovers is positive if the fraction of dealers with price information on other securities is high enough. Otherwise liquidity spillovers can be negative. For some parameters, the value of price information increases with the number of dealers obtaining this information. In this case, related securities can appear segmented, even if the cost of price information is small.
Keywords: Colocation; Contagion; Liquidity Risk; Liquidity Spillovers; Transparency; Value of Price Information
JEL Codes: G10; G12; G14
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| drop in liquidity for one security (E41) | raises uncertainty for dealers in other securities (G19) |
| raises uncertainty for dealers in other securities (G19) | affects their liquidity (G33) |
| liquidity of one security (E41) | affects liquidity of another (E44) |
| fraction of dealers who monitor prices (L81) | liquidity spillover effect (F65) |
| cross-security learning by dealers (G24) | amplifies liquidity shocks (E44) |
| small drop in liquidity in one market (E44) | disproportionately larger drop across related markets (F61) |
| change in risk tolerance among dealers (G40) | amplified effects on liquidity (E44) |
| increased price monitoring by dealers (D43) | improves liquidity (G33) |
| increased price monitoring by dealers (D43) | exposes inattentive dealers to adverse selection (D82) |