Funding Liquidity and Market Liquidity: The Broker-Dealer Perspective

Abstract

We provide the first direct analysis of how dealers' funding liquidity affects their liquidity provision in securities markets. Dealers' repo trading terms, including both haircuts and repo spreads, and their ability to finance their bond inventories through repos affect their bid-ask spreads and transaction costs in corporate bonds. Using dealers' exposure to the SEC 2016 money market fund reform as an instrument, we show that funding liquidity indeed has a causal effect on market liquidity. Dealers with lower funding liquidity tend to have smaller market shares and they execute more trades on an agency basis.

Keywords: funding liquidity, market liquidity, repos, broker-dealers, corporate bonds

JEL Classification: G12, G23, G24