Trading in Crowded Markets

Stepan Gorban (sgorban@nes.ru), Anna Obizhaeva (aobizhaeva@nes.ru) and Yajun Wang (ywang22@rhsmith.umd.edu.)
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Stepan Gorban: New Economic School
Anna Obizhaeva: New Economic School
Yajun Wang: University of Maryland

No w0275, Working Papers from New Economic School (NES)

Abstract: We study crowded markets using a symmetric continuous-time model with strategic informed traders. We model crowdedness by assuming that traders may have incorrect beliefs about the number of smart traders in the market and the correlation among private signals, which distort their inference, trading strategies, and market prices. If traders underestimate the crowdedness, then markets are more liquid, both permanent and temporary market depths tend to be higher, traders take larger positions and trade more on short-run profit opportunities. In contrast, if traders overestimate the crowdedness, then traders believe markets to be less liquid, they are more cautious in both trading on their information and supplying liquidity to others; fears of crowded markets may also lead to "illusion of liquidity" so that the actual endogenous market depth is even lower than what traders believe it to be. Crowdedness makes markets fragile, because flash crashes, triggered whenever some traders liquidate large positions at fire-sale rates, tend to be more pronounced.

Keywords: Asset Pricing; Market Liquidity; Market Microstructure; Crowding; Price Impact; Strategic Trading; Transaction Costs (search for similar items in EconPapers)
JEL-codes: B41 D8 G02 G12 G14 (search for similar items in EconPapers)
Pages: 54 pages
Date: 2020-08
New Economics Papers: this item is included in nep-mst
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