Miguel Sousa Lobo
Associate Professor of Decision Sciences
The authors describe how episodic illiquidity arises from a breakdown in cooperation between market participants. The authors first solve a one-period trading game in continuous-time, using an asset pricing equation that accounts for the price impact of trading. Then, in a multi-period framework, the authors describe an equilibrium in which traders cooperate most of the time through repeated interaction, providing apparent liquidity to one another.Cooperation breaks down when the stakes are high, leading to predatory trading and episodic illiquidity. Equilibrium strategies that involve cooperation across markets lead to less frequent episodic illiquidity, but cause contagion when cooperation breaks down.