Working Paper: CEPR ID: DP6179
Authors: Markus K. Brunnermeier; Lasse Heje Pedersen
Abstract: We provide a model that links an asset's market liquidity - i.e., the ease with which it is traded - and traders' funding liquidity - i.e., the ease with which they can obtain funding. Traders provide market liquidity, and their ability to do so depends on their availability of funding. Conversely, traders' funding, i.e., their capital and the margins they are charged, depend on the assets' market liquidity. We show that, under certain conditions, margins are destabilizing and market liquidity and funding liquidity are mutually reinforcing, leading to liquidity spirals. The model explains the empirically documented features that market liquidity (i) can suddenly dry up, (ii) has commonality across securities, (iii) is related to volatility, (iv) is subject to 'flight to quality', and (v) comoves with the market, and it provides new testable predictions.
Keywords: Counterparty credit risk; Leverage; Liquidity risk management; Margins; Systemic risk; Value-at-risk
JEL Codes: G1; G2
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| funding liquidity (E50) | market liquidity (G10) |
| market liquidity (G10) | funding liquidity (E50) |
| increasing margins (D43) | destabilizing effects on market liquidity (E44) |
| funding liquidity tightens (E44) | traders less willing to take positions (G19) |
| traders less willing to take positions (G19) | market liquidity decreases (G19) |
| market liquidity decreases (G19) | volatility increases (E32) |
| market liquidity can dry up (E44) | commonality across different securities (G10) |
| market liquidity sensitive to volatility (G19) | flight to quality phenomena (E44) |