Risk-averse Dealers in a Risk-free Market – The Role of Internal Risk Limits
46 Pages Posted: 14 May 2024
Date Written: March 1, 2024
Abstract
Self-imposed risk limits effectively limit dealers' appetite for risks and their capacity to intermediate in Treasury markets in times of market stress. Using granular and high frequency regulatory data on US dealers' Treasury securities trading desk positions and desk-level Value-at-Risk limits, we show that dealers are more inclined to reduce their positions as they get closer to their internal risk limit, consistent with such limit being meaningful and costly for traders to breach. Dealers actively manage their inventories away from their limits by selling longer-term securities and requiring higher compensation to take on additional risks. During the height of the Covid-crisis in 2020, dealer desks that were closer to their VaR limits sold more Treasury securities to the Fed and accepted lower prices in the emergency open market operations. Our findings complement studies that link post-GFC bank regulations to market liquidity by showing that self-imposed risk limits can explain the risk-averse behavior by dealers, and offers a micro-foundation for the link between market volatility and market liquidity in dealer-intermediated OTC markets. Policy prescriptions such as deregulation alone may not be sufficient to induce risk-taking by dealer intermediaries in times of crisis.
Keywords: Dealer Intermediation, Treasury Market, Risk Limits, Regulation, Market Liquidity
JEL Classification: G02, G23, E52
Suggested Citation: Suggested Citation