Working Paper: CEPR ID: DP16548
Authors: Max Bruche; John Chifong Kuong
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
JEL Codes: G12; G23; G24; G28
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| moral hazard problems (D82) | limited external financing (G32) |
| limited external financing (G32) | restricted ability to compete for providing liquidity (G19) |
| restricted ability to compete for providing liquidity (G19) | higher bid-ask spreads (G19) |
| moral hazard problems (D82) | higher bid-ask spreads (G19) |
| regulations affecting dealer leverage (G28) | market liquidity (G10) |
| increased leverage (G32) | improved liquidity (G19) |
| regulatory restrictions on leverage (G28) | negatively affect liquidity (G33) |