Dealer Funding and Market Liquidity

50 Pages Posted: 8 Nov 2018 Last revised: 9 Nov 2018

See all articles by Max Bruche

Max Bruche

Humboldt University of Berlin

John Chi-Fong Kuong

INSEAD - Finance

Date Written: November 8, 2018

Abstract

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

Bruche, Max and Kuong, John Chi-Fong, Dealer Funding and Market Liquidity (November 8, 2018). 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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