Title: Trading in Crowded Markets
Abstract: We study crowded markets using a symmetric model of trading among strategic informed traders. We model market crowdedness by assuming that traders may have incorrect beliefs about either the number of smart traders or the correlation among traders’ private signals; this distorts traders’ inference, strategies, and market prices. If traders underestimate the degree of crowdedness, then markets are more liquid, both permanent and temporary market depths tend to be higher, traders take larger positions and trade more aggressively on short-run profit opportunities. In contrast, as soon as traders start overestimating the degree of crowdedness, they believe markets to be less liquid and trade more cautiously on both their private information and supplying liquidity to others. Fears of crowded markets may also lead to “illusion of liquidity” when the actual endogenous mar- ket depth is even lower than what traders believe it to be. Crowded markets are fragile, because flash crashes, triggered whenever some traders liquidate large positions at fire-sale rates, tend to be more pronounced.