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Review of Finance Advance Access published online on February 7, 2008
Review of Finance, doi:10.1093/rof/rfm023
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Copyright © The Author 2008. Published by Oxford University Press on behalf of the European Finance Association.

Informed Traders as Liquidity Providers: Anonymity, Liquidity and Price Formation

Barbara Rindi*,

Bocconi University

The tendency to introduce anonymity into financial markets apparently runs counter to the theory supporting transparency. This paper studies the impact of pre-trade transparency on liquidity in a market where risk-averse traders accommodate the liquidity demand of noise traders. When some risk-averse investors become informed, an adverse selection problem ensues for the others, making them reluctant to supply liquidity. Hence the disclosure of traders' identities improves liquidity by mitigating adverse selection. However, informed investors are effective liquidity suppliers, as their adverse selection and inventory costs are minimized. With endogenous information acquisition, transparency reduces the number of informed investors, thus decreasing liquidity. The type of information that traders hold and the effectiveness of insider trading regulation are crucial to distinguish between equilibria.

* With thanks to Bruno Biais and Giovanna Nicodano for their extremely helpful comments and suggestions. I also thank the editor Josef Zechner, Ekkehart Boehmer, Gabriella Chiesa, Francesco Corielli, Thierry Foucault, Paolo Fulghieri, Alexander Guembel, Eugene Kandel, Stefano Lovo, Kjell Nyborg, Avi Whol, Maureen O'Hara, Marco Pagano, Duanne Seppi, two anonymous referees, and seminar participants in Toulouse, HEC, Padua, Turin and Bocconi University, and EFA 2002 Conference in Berlin, ESSFM 2002 in Gerzensee and RES 2002 in Warwick for helpful comments. The usual disclaimer applies. I acknowledge financial support from Bocconi University ("Ricerca di Base" project).


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