Information, Rebalancing and Circuit Breakers

We investigate the structure and welfare contribution of markets where traders who face a future uncertain liquidity shock may engage in excessive trading. We model multi-period trading subject to both market-maker rebalancing and common information updates. We study the cross interaction between trading volumes, rebalancing capacity and the existence of information updates and evaluate the impact of circuit breakers in such a setup. We address the tension between the incentive to close the markets, thereby avoiding market runs, and the alternative which allows the markets to take their course so as to smooth the price impact. When rebalancing capacity is low the existence of markets always lowers ex-ante welfare, this damaging effect cannot be cured with a single period no-trading circuit breaker. When rebalancing is high markets improve welfare. Moreover, in the absence of information updates, when the existence of markets is welfare enhancing, a single-period no-trading circuit breaker cannot further improve welfare. However when information updates are expected, market performance may be improved by implementing single period circuit-breakers. Surprisingly, under certain conditions such a circuit breaker should only be triggered when markets attempt a full run. The positive ex-ante welfare impact of markets increases with information volatility, asset volatility and the market makers risk aversion and decreases with the likelihood of future liquidity shocks.

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