We study the transmission of liquidity shocks from one sector of the economy to other sectors in a general equilibrium model with multiple trading venues connected by profit-seeking arbitrageurs. Arbitrageurs effectively provide liquidity to investors by intermediating trades between venues. The welfare impact on venue k of a liquidity shock on venue l can go in either direction, depending on whether intermediated trades on k behave as complements or substitutes for such trades on l. In addition to this direct effect through the arbitrage network, there is a feedback effect of an adverse shock reducing liquidity and arbitrageur profits, which leads to a lower level of intermediation, further reducing liquidity. We illustrate this contagion with examples of high-frequency trading in equity markets, shocks to one tranche of a collateralized debt obligation impacting investors in the other tranches, carry trade crashes, shocks to cross-country bank lending following the global financial crisis, and the bursting of the Japanese bubble in the early 1990s.
Systemic Risk Centre Discussion Papers DP 102
Financial Markets Group Discussion Papers DP 812