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 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.