The Effect Of Margin-buying And Short-selling On Liquidity And Liquidity Black Hole

Liquidity is an essential ingredient of an efficient and stable financial market.The turmoil of financial market caused by liquidity crisis in recent years not only results in substantial losses to investors but also presents great challenges to regulators and policy makers.Thus,the research on liquidity and particularly liquidity black hole has become an ever timely and important topic in finance.In this dissertation,I propose a theoretical framework based on limit order book to describe the dynamic mechanism of liquidity black hole.The limit order book provides an ideal framework to examine liquidity black hole.That is,when market depth is so low and limit order book is almost empty,it directly leads to a liquidity black hole.Moreover,motivated by the fact that the Chinese stock market relaxes constraints on margin-buying and short-selling starting in March of 2010,I use the aforementioned theoretical framework to examine the effect of margin-buying and short-selling on liquidity in general and liquidity black hole in particular.Finally,I perform empirical analysis to test various hypotheses derived under the theoretical framework.Three parts of the dissertation are summarized as follows.In the first part,I propose a theoretical framework based on limit order book to examine the dynamic mechanism of liquidity black hole,especially when the market goes down.I propose a three-period theoretical framework where Period 1 represents a normal market condition.Negative shock occurs in Period 2,resulting in a clear decrease in market liquidity.In period 3,under the worst scenario,the clear decrease in market liquidity has a feedback effect on uninformed traders,causing them to withdraw their orders from the market.In turn,informed traders exit the market due to the increase of market uncertainty.The market experiences liquidity run,and liquidity black hole occurs.In the second part,I examine the effect of margin-buying and short-selling on liquidity.If investors tend to submit limit orders,margin-buying and shortselling likely increase liquidity;in contrast,if investors tend to submit market orders or marketable limit orders,the presence of informed traders is likely to cause uninformed traders' adverse selection(i.e.,withdraw their orders from the market),margin-buying and short-selling likely decrease liquidity.When the dispersion is high,margin-buying and short-selling likely lead to more investors purchasing on margin and selling short,more likely to cause uninformed traders' adverse selection,thus will have a larger negative effect on liquidity.Starting on March 31,2010,the Chinese stock market relaxes constraints on margin-buying and short-selling.By September 22,2014,the list of stocks is expanded from original 90 to 900.I employ the difference-in-differences methodology as well as multivariate regression to examine the effect of margin-buying and short-selling on liquidity.The main findings are summarized as follows:(1)the empirical results show an overall significantly negative effect of margin-buying and shortselling on liquidity.Specifically,using price impact of trading to proxy liquidity,while there is a significant improvement of liquidity for stocks in the treated group(i.e.stocks that are allowed to purchase on margin and sell short)during the postevent period(i.e.,relaxation of the constraints on margin-buying and short-selling)than during the pre-event period,the improvement of liquidity for stocks in the treated group is significantly smaller than those stocks in the control group.This is an evidence of a significantly negative effect of margin-buying and short-selling on liquidity.(2)Using the dispersion in analysts' earnings forecast and idiosyncratic volatility as proxies of dispersion of investor opinion,the empirical results further show that the negative effect on liquidity is more pronounced for stocks with a higher dispersion of investor opinion.In the third part,I examine the effect of margin-buying and short-selling on liquidity black hole based on the three-period theoretical framework developed in the first part.The clear decrease in liquidity caused by negative shock may have a feedback effect on uninformed traders,causing them to withdraw their orders from the market.When this is coupled by substantial decrease in security price,margin calls may occur and short selling may become aggressive.Both activities will aggravate liquidity and increase the likelihood of liquidity black hole.When the dispersion is high,margin-buying and short-selling likely lead to more aggressive short selling and may trigger more margin calls,which will have a greater feedback effect on uninformed traders.As a result,liquidity black hole more likely to happen.I employ the difference-in-differences methodology as well as multivariate regression to examine the effect of margin-buying and shortselling on liquidity black hole.The main findings are summarized as follows: the empirical results show an overall significantly negative effect of margin-buying and short-selling on liquidity black hole.Liquidity black hole is defined as the case when illiquidity of a stock is more than 2 standard deviations above the average level over the past 250 days.While the likelihood of liquidity black hole for stocks in the treated group significantly decreases after constrains on marginbuying and short-selling are relaxed,it is significantly smaller than those stocks in the control group.This is an evidence of a significantly negative effect of margin-buying and short-selling on liquidity black hole.Again,the effect is more pronounced for stocks with a higher dispersion of investor opinion.Margin traders,especially short sellers,are more likely to be informed traders(Chang et al.,2014).Investors who possess private information can make better use of the asymmetric information by margin trading.Afraid of being taken advantage of by informed traders,uninformed traders avoid trading with them to reduce risk(Ausubel 1990).Besides,manipulation and insider trading are widespread in China(Chakravarty et al.,1998;Chan et al.,2008).Therefore,uninformed traders may avoid stocks that are allowed to purchase on margin and sell short,resulting in a reduction in liquidity.If uninformed traders stop trading,informed traders may give up trading in case of leaking out their information(Milgrom and Stokey,1982),resulting in a further decrease in liquidity.When the dispersion is high,information asymmetry risk is high,which is more likely to cause the adverse selection of uninformed traders,thus margin-buying and shortselling have a larger negative impact on liquidity and liquidity black hole.The empirical findings of our analysis not only are important for investors to understand liquidity risk of their investment but also provide useful evidences for regulators and policy makers in their assessment and management of liquidity risk and particularly extreme liquidity risk of the market.