DP16548 Dealer Funding and Market Liquidity
|Author(s):||Max Bruche, John Chi-Fong Kuong|
|Publication Date:||September 2021|
|Keyword(s):||Dealers, Immediacy, market liquidity, Optimal Contract, Regulation|
|JEL(s):||G12, G23, G24, G28|
|Programme Areas:||Financial Economics|
|Link to this Page:||cepr.org/active/publications/discussion_papers/dp.php?dpno=16548|
We consider a model in which dealers intermediate trades between clients and provide immediacy, or, market liquidity. Dealers can exert unobservable search effort to improve the chance of intermediating profitably. This moral-hazard friction impairs dealers' ability to raise external finance and hence to compete aggressively with each other in providing liquidity. Market liquidity is limited even for safe assets and more so for assets with higher search cost. To alleviate the financing friction, dealers opt to finance with debt and intermediate in several markets simultaneously. Dealer leverage is therefore endogenous and related to variations in liquidity across otherwise unrelated markets. Our results shed light on how post-crisis regulations influence the provision of immediacy in bond markets.