This working paper looks at causes for the occurrence of liquidity (or
illiquidity) spillovers across markets and proposes a novel theoretical
explanation that provides interesting insights into recent events, for example
the 'Flash Crash' of May 2010.
Dealers use prices of other securities as a source of information. As prices of
less liquid securities convey less precise information, a drop in liquidity for
one security raises the uncertainty for dealers in other securities, thereby
affecting their liquidity.
The direction of liquidity spillovers is positive if the fraction of dealers
with price information on other securities is high enough. Otherwise liquidity
spillovers can be negative. A new mechanism is described that explains the
transmission of liquidity shocks from one security to another ('liquidity
This article forms part of a wider research project in which the research team
will look at the behaviour of liquidity in financial markets.
The full working paper is now available for you to download below. Let us know
what you think in the comments box.