Market Opacity and Fragility

We show that, consistent with empirical evidence, access to order flow information allows traders to supply liquidity via contrarian marketable orders. An informational friction resulting from lack of market transparency can, however, make liquidity demand upward sloping, inducing strategic complementarities: traders demand more liquidity when the market becomes less liquid, fostering market illiquidity. This can generate instability with an initial dearth of liquidity degenerating into a liquidity rout (as in a flash crash), an event that is more likely to occur when market opacity hampers liquidity supply via marketable orders. Our theory also predicts that, when the market is fragile, traders faced with the largest price impact are those consuming more liquidity at equilibrium. An increase in order flow transparency and/or in the mass of dealers who are in the market at all times has a positive impact on total welfare