Correlated Portfolio Inventory Risk of Liquidity Providers: Frictions and Market Fragility

Abstract

We investigate, for limit order book equity markets, how trading, liquidity provision, and the overall market quality in one security are influenced by correlated inventory risk exposures of liquidity providers to other securities in their portfolios. We find strong support for Ho and Stoll (1983). Our results are also consistent with large and correlated portfolio inventories worsening different measures of market quality – including bid-ask spreads and pricing errors – and increasing the number and likelihood of extreme price movements and transitory jumps in stock returns. We accordingly highlight a significant but often overlooked source of market frictions, contagion, and fragility.