Liquidity Crises Due to Asymmetric Information

Abstract

This paper considers a model where both market liquidity and funding liquidity depend on the information in the market. Speculators are constrained by margins on their positions, the margins are set by financiers, who has less information than the speculators. The paper shows how this can result in fragile financial markets. The model considers multiple assets, and it is shown that when speculators are profit- maximizing, margins may be destabilizing which does not happen with passive speculators that only provide liquidity. Margins depend on the initial holdings of the speculator, the initial illiquidity, and the variance of the financiers information and may be both increasing or decreasing depending on the trade and the sign of initial holding of the speculator. Correlation of the returns also has an impact on the mar- gins and stability in the market. The model predicts that uncertainty about future returns is a driver of market liquidity and has several predictions regarding margins and stability of the financial market.