Funding Constraints and Liquidity in Two-Tiered OTC Markets

Abstract

Using primary dealer transactional data from the UK government bond (gilt) market, we identify a new channel through which dealer funding constraints may impair liquidity in two-tiered OTC markets. The key finding is that funding constraints also inhibit dealers' ability to accommodate each others' trade requests in the inter-dealer segment, which limits their collective ability to manage inventories and share risk. As a result, funding constraints end up compromising liquidity above and beyond any direct effects caused by individual dealers' inability to accommodate client trade requests due to their individual balance sheet constraints.

Keywords: gilt market, liquidity, inter-dealer trading

JEL Classification: G10, G12, G14