Dealer Funding and Market Liquidity

Abstract

We consider a model in which dealers need to raise external financing to provide immediacy to their clients, and also exert unobservable effort to improve the chance of closing their positions at a profit. This moral hazard problem reduces the amount of external finance dealers can raise, and therefore reduces intermediation volume, softens competition between dealers, and widens bid-ask spreads, and in this sense has a negative effect on the market liquidity of intermediated assets. When dealers suffer losses, the problem becomes worse. Effects are stronger for riskier assets. Endogenous correlations and non-monotonic liquidity spillovers arise between otherwise unrelated assets. As the optimal financing arrangement involves debt, regulations that limits the leverage of bank-affiliated dealers can have adverse effects on market liquidity.