Episodic Liquidity Crises: Cooperative and Predatory Trading





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    • Bruce Ian Carlin is from the Anderson Graduate School of Management, University of California at Los Angeles. Miguel Sousa Lobo and S. Viswanathan are from the Fuqua School of Business at Duke University. The authors would like to thank Robert Almgren, Yacov Amihud, Kerry Back, Ravi Bansal, Michael Brandt, Markus Brunnermeier, Bhagwan Chowdry, Phil Dybvig, Simon Gervais, Milt Harris, Roy Henriksson, Ming Huang, Ron Kaniel, Arvind Krishnamurthy, Pete Kyle, Leslie Marx, Atif Mian, David Mordecai, Lasse Pedersen, Matt Pritsker, Uday Rajan, Ioanid Rosu, Ronnie Sadka, Louis Scott, Duane Seppi, Jim Smith, Matt Spiegel, Curt Taylor, Jiang Wang, Huseyin Yildirim, an anonymous referee, and seminar participants in the 2005 World Congress of Economics, the 2005 New York Federal Reserve Bank conference on liquidity, the 2006 Atlanta Federal Reserve conference on risk, the IAFE Liquidity Risk Symposium, the 2006 Mitsui Life Financial Center Symposium, the Duke Finance and Duke Economics seminars, and the Indian School of Business for their comments.


We describe how episodic illiquidity arises from a breakdown in cooperation between market participants. We first solve a one-period trading game in continuous-time, using an asset pricing equation that accounts for the price impact of trading. Then, in a multi-period framework, we describe an equilibrium in which traders cooperate most of the time through repeated interaction, providing apparent liquidity to one another. Cooperation breaks down when the stakes are high, leading to predatory trading and episodic illiquidity. Equilibrium strategies that involve cooperation across markets lead to less frequent episodic illiquidity, but cause contagion when cooperation breaks down.