A Welfare Analysis of Fragmented Liquidity Markets

Guembel, Alexander and Sussman, Oren (2014) A Welfare Analysis of Fragmented Liquidity Markets. TSE Working Paper, n. 14-498

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Official URL: http://tse-fr.eu/pub/28250


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.

Item Type: Monograph (Working Paper)
Language: English
Date: March 2014
Uncontrolled Keywords: Contagion, fire sales, market integration
Divisions: TSM Research (Toulouse), TSE-R (Toulouse)
Site: UT1
Date Deposited: 09 Jul 2014 17:45
Last Modified: 07 Mar 2018 13:22
OAI ID: oai:tse-fr.eu:28250
URI: http://publications.ut-capitole.fr/id/eprint/15939

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