Arbitrage with Financial Constraints and Market Power
60 Pages Posted: 26 Jun 2020 Last revised: 31 Jul 2023
Date Written: July 31, 2023
I study how (VaR-based) financial constraints affect liquidity and welfare under different structures of the arbitrage industry. When capital is dispersed across competitive arbitrageurs, financial constraints may impair their ability to provide liquidity, lowering other investors' welfare. However, when capital is concentrated among arbitrageurs with market power, introducing constraints can make everyone better off and increase liquidity. Further, alternative constraints (fixed margins, position limits) have the same effects as VaR constraints when arbitrageurs are competitive, but not when they have market power. These results lead to new policy implications for margin and capital requirements and yield new empirical predictions.
Keywords: Limits of arbitrage, liquidity, strategic arbitrage, market structure, price impact, margin requirements, market power
JEL Classification: G12, D41, D60
Suggested Citation: Suggested Citation