The Volcker Rule and the Hedge Fund Liquidity Circle

Abstract

The implementation of the Volcker Rule (section 619 of the 2010 Dodd-Frank Act)
profoundly impacts the funding liquidity of hedge funds, their liquidity risk exposure
and liquidity provision to the market. Analysing a sample of 5,697 hedge funds, we find that following the legislation, capital flows to hedge funds decline, and their flow-performance sensitivity increases. Hedge funds reduce their market liquidity exposure and realign their market-making activities towards the most liquid stocks. These results support the Brunnermeier-Pedersen model of illiquidity spirals.

Keywords: Volcker Rule, Hedge funds, Liquidity risk, Liquidity provision, Fund flows

JEL Classification: G1, G18, G2, G23, G28