Risk-averse Dealers in a Risk-free Market - The Role of Trading Desk Risk Limits

Dan Li, Lubomir Petrasek and Mary Tian
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Lubomir Petrasek: https://www.federalreserve.gov/econres/lubomir-petrasek.htm
Mary Tian: https://www.federalreserve.gov/econres/mary-tian.htm

No 2025-034, Finance and Economics Discussion Series from Board of Governors of the Federal Reserve System (U.S.)

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 provide a micro-foundation for the link between market volatility and market liquidity in dealer-intermediated OTC markets. In times of crisis, policy prescriptions such as deregulation alone may not be sufficient to induce risk-taking by dealer intermediaries. Moreover, to address market functioning issues, policy actions that address the funding costs of intermediaries would not be as effective as policies that remove risks from intermediary balance sheets directly.

Keywords: Dealer intermediation capacity; Treasury market; Risk limits; Regulation; Market liquidity (search for similar items in EconPapers)
JEL-codes: E52 G01 G23 (search for similar items in EconPapers)
Pages: 56 p.
Date: 2025-05-15
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Persistent link: https://EconPapers.repec.org/RePEc:fip:fedgfe:2025-34

DOI: 10.17016/FEDS.2025.034

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