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Commonality in Liquidity Shocks and Market Collapse : Theory and Application to the Market for Perps *

Traditional explanations of market collapse rely on the bursting of an asset price bubble or significant information asymmetry across market participants about fundamental value. We show that markets can collapse even though asset prices have not deviated from fundamental values and information is shared symmetrically among all market participants. We present a model in which markets collapse when investors shift their beliefs about market liquidity. While such shifts in liquidity may be a factor in explaining many market collapses, the collapse of the market for perpetual floating-rate notes (perps) seems to provide an especially clear illustration of the theory because a shift in liquidity beliefs appears to have been the primary determinant of the collapse of the market for perps. Such a shift can be precipitated by a common liquidity shock, and can be transitory or permanent. The latter proved to be the case with perps because perceptions of the liquidity of the secondary market for perps were permanently altered. In addition to providing new insights into why markets collapse, our findings are particularly relevant for unseasoned financial products that are often priced and marketed on the assumption that liquid secondary markets will develop. The collapse of the market for perps also highlights the importance of broad placement of securities. As our model illustrates, market liquidity arises endogenously from the diversity of liquidity needs across the investor base and therefore, the broader the investor base, the lower the probability of a common liquidity shock.