Constrained Dealers and Market Efficiency
56 Pages Posted: 5 Nov 2021 Last revised: 20 Dec 2021
Date Written: November 4, 2021
We analyse how constraints on dealers’ risk-bearing capacity affect market efficiency in the foreign exchange (FX) market. Dealers support market efficiency by accommodating their customers’ trading demands through elastic liquidity provision in normal times but when they face constraints their elasticity of liquidity provision weakens. Episodes of tight dealer constraints – for instance, due to high leverage, Value-at-Risk, and funding costs – in turn go hand in hand with price inefficiencies due to law of one price deviations and elevated trading costs. We rationalise our novel empirical findings with a tractable model that sheds light on the key mechanisms of how market efficiency can deteriorate when dealers are more constrained.
Keywords: Market Efficiency, Dealer Constraints, Foreign Exchange, Liquidity Provision.
JEL Classification: F31, G12, G15
Suggested Citation: Suggested Citation