Dealer Funding and Market Liquidity
50 Pages Posted: 8 Nov 2018 Last revised: 9 Nov 2018
Date Written: November 8, 2018
We consider a model in which dealers need to raise external financing to provide liquidity, and also exert unobservable effort to improve the chance of closing a position at a profit. This moral hazard problem affects how and how much external finance dealers can raise. Therefore, it limits intermediation volume, soften competition between dealers, and widens bid-ask spreads. When dealers suffer losses, the problem becomes worse. Effects are stronger for riskier assets. Endogenous correlation and contagion in liquidity 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: Suggested Citation