Dealer Funding and Market Liquidity

John Chi-Fong Kuong and Max Bruche

No 16548, CEPR Discussion Papers from Centre for Economic Policy Research

Abstract: 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.

Keywords: Dealers; Market liquidity; Immediacy; Regulation; Optimal contract (search for similar items in EconPapers)
JEL-codes: G12 G23 G24 G28 (search for similar items in EconPapers)
Date: 2021-09
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