Constrained Dealers and Market Efficiency

56 Pages Posted: 5 Nov 2021 Last revised: 20 Dec 2021

See all articles by Wenqian Huang

Wenqian Huang

Bank for International Settlements

Angelo Ranaldo

University of St. Gallen

Andreas Schrimpf

Bank for International Settlements (BIS) - Monetary and Economic Department; CREATES - Aarhus University

Fabricius Somogyi

University of St. Gallen

Date Written: November 4, 2021

Abstract

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

Huang, Wenqian and Ranaldo, Angelo and Schrimpf, Andreas and Schrimpf, Andreas and Somogyi, Fabricius, Constrained Dealers and Market Efficiency (November 4, 2021). University of St.Gallen, School of Finance Research Paper No. 2021/16 , Available at SSRN: https://ssrn.com/abstract=3956582. or http://dx.doi.org/10.2139/ssrn.3956582

Wenqian Huang (Contact Author)

Bank for International Settlements ( email )

Centralbahnplatz 2
Basel, Basel-Stadt 4002
Switzerland

HOME PAGE: http://wenqianhuang.org

Angelo Ranaldo

University of St. Gallen ( email )

Swiss Institute of Banking and Finance s/bf-HSG
Unterer Graben 21
St. Gallen, 9000
Switzerland
+41712247010 (Phone)

HOME PAGE: http://www.sbf.unisg.ch/Lehrstuehle/Lehrstuhl_Ranaldo/Homepage_Ranaldo.aspx

Andreas Schrimpf

Bank for International Settlements (BIS) - Monetary and Economic Department ( email )

Centralbahnplatz 2
CH-4002 Basel
Switzerland

CREATES - Aarhus University ( email )

School of Economics and Management
Building 1322, Bartholins Alle 10
DK-8000 Aarhus C
Denmark

Fabricius Somogyi

University of St. Gallen ( email )

Unterer Graben 21
St.Gallen, CH-9000
Switzerland

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