Dealer Funding and Market Liquidity

53 Pages Posted: 8 Nov 2018 Last revised: 12 Jul 2019

See all articles by Max Bruche

Max Bruche

Humboldt University of Berlin

John Chi-Fong Kuong

INSEAD - Finance

Date Written: June 30, 2019

Abstract

We consider a model in which dealers need to raise external financing to provide immediacy to their clients, and also exert unobservable effort to improve the chance of closing their positions at a profit. This moral hazard problem reduces the amount of external finance dealers can raise, and therefore reduces intermediation volume, softens competition between dealers, and widens bid-ask spreads, and in this sense has a negative effect on the market liquidity of intermediated assets. When dealers suffer losses, the problem becomes worse. Effects are stronger for riskier assets. Endogenous correlations and liquidity spillovers arise between otherwise unrelated assets. As the optimal financing arrangement involves debt, regulations that limits the leverage of bank-affiliated dealers can have adverse effects on market liquidity.

Keywords: dealers, market-making, asset liquidity, moral hazard, regulation

JEL Classification: G23, G24

Suggested Citation

Bruche, Max and Kuong, John Chi-Fong, Dealer Funding and Market Liquidity (June 30, 2019). Available at SSRN: https://ssrn.com/abstract=3281303 or http://dx.doi.org/10.2139/ssrn.3281303

Max Bruche

Humboldt University of Berlin ( email )

Spandauer Str. 1
Berlin, D-10099
Germany

HOME PAGE: http://www.maxbruche.net

John Chi-Fong Kuong (Contact Author)

INSEAD - Finance ( email )

Boulevard de Constance
77305 Fontainebleau Cedex
France

HOME PAGE: http://www.johncfkuong.com

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