Dealer Funding and Market Liquidity
Abstract
We analyze a model where dealers provide market liquidity by intermediating trades between clients. They exert unobservable search effort to improve intermediation profit. This moral-hazard friction limits their ability to raise external finance and compete with each other, constraining market liquidity even for safe assets and more so for those with higher search costs. Dealers mitigate this friction by using debt financing and intermediating across multiple markets, making leverage endogenous and linked to liquidity variations in otherwise unrelated markets. Capping leverage reduces dealer external financing and has mixed effects on welfare. It worsens liquidity but encourages effort. Our findings illuminate how postcrisis regulations impact bond market liquidity.
This paper was accepted by William Cong, finance.
Funding: J. C.-F. Kuong gratefully acknowledges the financial support from INSEAD and HKIMR.
Supplemental Material: The online appendix is available at https://doi.org/10.1287/mnsc.2022.02278.
