Stock Market Declines and Liquidity

Consistent with recent theoretical models where binding capital constraints lead to sudden liquidity dry-ups, we find that negative market returns decrease stock liquidity, especially during times of tightness in the funding market. The asymmetric effect of changes in aggregate asset values on liquidity and commonality in liquidity cannot be fully explained by changes in demand for liquidity or volatility effects. We document interindustry spillover effects in liquidity, which are likely to arise from capital constraints in the market making sector. We also find economically significant returns to supplying liquidity following periods of large drops in market valuations. In recent theoretical research, the idea that market declines cause asset illiquidity has received much attention. Liquidity dry-ups are argued to occur because market participants engage in panic selling (a demand effect), finan cial intermediaries withdraw from providing liquidity (a supply effect), or both. In this paper, we explore empirically what happens to market liquidity after large market declines and whether supply effects exist in equity markets. It is difficult to establish the actual identity of financial intermediaries in equity markets as they could be specialists, floor traders, limit order providers, or other traders like hedge funds. Furthermore, the actual positions and balance sheets of these intermediaries are unknown. We therefore take an encompass ing approach by investigating the impact of market declines on various dimen sions of liquidity, including: (1) time-series as well as cross-sectional variation in liquidity; (2) commonality in liquidity; and (3) cost of liquidity provision. Theoretical models obtain illiquidity after market declines in a variety of ways. In collateral-based models, market makers make markets by absorbing