Constrained liquidity provision in currency markets

Wenqian Huang, Angelo Ranaldo, Andreas Schrimpf and Fabricius Somogyi

Journal of Financial Economics, 2025, vol. 167, issue C

Abstract: We devise a simple model of liquidity demand and supply to study dealers’ liquidity provision in currency markets. Drawing on a globally representative data set of currency trading volumes, we show that at times when dealers’ intermediation capacity is constrained the cost of liquidity provision increases disproportionately relative to dealer-intermediated volume. Consequently, the otherwise strong and positive relation between liquidity costs and trading volume diminishes significantly when dealers face tighter Value-at-Risk limits or higher funding costs. Using various econometric approaches, we show that this nonlinear effect of dealer constraints on market liquidity primarily stems from a reduction in the elasticity of liquidity supply, rather than changes in liquidity demand.

Keywords: Currency markets; Dealer constraints; Market liquidity; FX; Liquidity provision (search for similar items in EconPapers)
JEL-codes: F31 G12 G15 (search for similar items in EconPapers)
Date: 2025
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Persistent link: https://EconPapers.repec.org/RePEc:eee:jfinec:v:167:y:2025:i:c:s0304405x25000364

DOI: 10.1016/j.jfineco.2025.104028

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