Informed Trading and Co-Illiquidity

Abstract

We study the link between informed trading and co-movement in illiquidity. We argue that investors concerned with liquidity and fire-sale shocks respond to an increase in informed trading by shifting their portfolios away from stocks with high information asymmetry. This rebalancing causes a substitution in ownership away from the investors who induce financial fragility and co-movement in illiquidity, reducing the co-illiquidity of affected stocks. We exploit two experiments – the SHO experiment and the short selling bans – that impact the incentives/ability of informed traders to trade. The results suggest that informed traders ameliorate co-movement in illiquidity, a major problem that emerged during the global financial crisis.