Trading in Crowded Markets

We study crowded markets using a symmetric model of trading among strategic informed traders. Traders may have incorrect beliefs about markets' crowdedness; this distorts traders' strategies and market prices. When traders overestimate the crowdedness, they believe markets to be less liquid and trade more cautiously. Fears of crowded markets lead to an "illusion of liquidity,'' when the actual endogenous market depth is even lower than what traders believe it to be. Crowded markets are fragile, because flash crashes, triggered whenever some traders liquidate large positions quickly, tend to be more pronounced and price recoveries after crashes tend to be slower