Dealer Funding and Market Liquidity
71 Pages Posted: 8 Nov 2018 Last revised: 5 Oct 2020
Date Written: September 30, 2020
We consider a model in which dealers intermediate trades between clients and provide immediacy, or, market liquidity. Dealers can exert unobservable effort to improve the chance of intermediating profitably. This moral-hazard friction impairs dealers’ ability to raise external finance and hence to compete aggressively with each other in providing liquidity. To alleviate the financing friction, dealers opt to finance with debt and intermediate in several markets simultaneously. Dealer leverage is therefore endogenous and related to variations in liquidity across otherwise unrelated markets. Our results shed light on the developments of intermediation in bond markets in response to post-crisis bank regulations.
Keywords: dealers, market-making, asset liquidity, moral hazard, regulation
JEL Classification: G23, G24
Suggested Citation: Suggested Citation