Market liquidity and funding liquidity

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Market liquidity and funding liquidity

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Market liquidity and funding liquidity

Markus K. Brunnermeier¹, Lasse Heje Pedersen²•Institutions (2)

Princeton University¹, New York University²

01 Feb 2007-Research Papers in Economics (Financial Markets Group)-

TL;DR: In this article, the authors provide a model that links an asset's market liquidity and traders' funding liquidity, i.e., the ease with which they can obtain funding, to explain the empirically documented features that market liquidity can suddenly dry up, has commonality across securities, is related to volatility, is subject to flight to quality, and comoves with the market.

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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: Liquidity Risk Management, Liquidity, Liquidation, Systemic Risk, Leverage, Margins, Haircuts, Value-at-Risk, Counterparty Credit Risk

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Interdependence of Liquidity Problems in the Financial Sector

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Sebastian Missio¹•Institutions (1)

Ludwig Maximilian University of Munich¹

01 Jan 2011

TL;DR: In this article, problems arising from the interdependence of liquidity provision in the financial system were analyzed and it was shown that liquidity shortage of minor financial players can translate into liquidity shortage for systemic relevant players, thereby putting the proper functioning of the overall financial system on the line.

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Abstract: The paper analyses problems arising from the interdependence of liquidity provision in the financial system. Findings document, that liquidity shortage of minor financial players can translate into liquidity shortage for systemic relevant players, thereby putting the proper functioning of the overall financial system on the line. As contractual mechanisms to safeguard against this threat are absent in the wake of market frictions, prudent regulation and governmental provision of external liquidity is asked for in order to solve these problems. JEL classification: G01, G21

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Posted Content•

On the role of market makers for money market liquidity and tensions

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Falko Fecht, Stefan Reitz¹, Patrick Weber•Institutions (1)

Kiel Institute for the World Economy¹

01 Jan 2015-Research Papers in Economics

TL;DR: In this paper, the authors analyzed the trading book of a key market maker in the European unsecured money market and studied the extent to which liquidity risks accumulated by this market maker affect his pricing of liquidity and the bid/ask spread he quotes on unstructured borrowing and lending, finding that the larger the funding liquidity risk assumed by the market maker, the higher the market price for liquidity.

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Abstract: We analyze the trading book of a key market maker in the European unsecured money market and study the extent to which liquidity risks accumulated by this market maker affect his pricing of liquidity and the bid/ask spread he quotes on unsecured borrowing and lending. We find that the larger the funding liquidity risk assumed by the market maker is, the higher the market price for liquidity. Furthermore, his bid/ask spread and the sensitivity of his bid/ask spread to the maturity of the transaction increases as his assumed liquidity risk rises. Our findings have two important implications: First, we document that the funding constraints and funding risks of market makers affect market liquidity in line with Gromp and Vayanos (2004) and Brunnermeier and Pedersen (2009) also in the unsecured money market. Second, we document that the retained liquidity risks of money market makers led to an economically significant rise in the unsecured to secured money market rates and contributed to the dry-up of this market in 2007/2008.

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Cites background or result from "Market liquidity and funding liquid..."

...Hence, very much along the lines of Brunnermeier and Pedersen (2009), we find that a higher funding liquidity risk of the market maker indeed increases the market price of liquidity. Moreover, we find evidence for a destabilizing reinforcement between funding liquidity risks of a market maker and the realized bid/ask spread in the money market as theoretical models such as Gromb and Vayanos (2002) would suggest....
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...While Gromb and Vayanos (2004) and Brunnermeier and Pedersen (2009) neglect the OTC market structure with search frictions in their models, they show that funding restraints and funding risks of market makers are important determinants for asset market liquidity....
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...Therefore, these documented effects have the potential to give rise to adverse liquidity spirals as suggested in Brunnermeier and Pedersen (2009). These results have important policy implications....
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...Hence, very much along the lines of Brunnermeier and Pedersen (2009), we find that a higher funding liquidity risk of the market maker indeed increases the market price of liquidity....
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...Therefore, these documented effects have the potential to give rise to adverse liquidity spirals as suggested in Brunnermeier and Pedersen (2009)....
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Journal Article•DOI•

The Dynamics of Trading in Commodity Futures

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Aditya Kaul¹, Lorenzo Naranjo², Carmen Stefanescu³•Institutions (3)

University of Alberta¹, University of Miami², ESSEC Business School³

18 Aug 2013-Social Science Research Network

TL;DR: This article examined weekly trading imbalances for speculators and small investors in the commodity futures market and their price and volatility effects over the period 1986-2012, concluding that speculators behave like short-term momentum traders and long-term contrarians.

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Abstract: We examine weekly trading imbalances for speculators and small investors in the commodity futures market and their price and volatility effects over the period 1986-2012. First, speculators behave like short term momentum traders and long-term contrarians. Their imbalances are positively autocorrelated and positively cross-autocorrelated with small investor imbalances, consistent with their ‘riding the wave’ caused by small traders. Speculators sell (buy) to a greater extent after their long (short) positions have become larger, especially when volatility is elevated: this is consistent with their being risk averse. Small trader imbalances also follow speculator imbalances of a given sign, and display mean reversion and volatility aversion, but both are weaker than for speculators. Second, imbalances have positive and significant permanent price effects, which are larger for speculators. Further analysis suggests that the price impact of speculator imbalances is smaller when they act as suppliers of liquidity to hedgers. Finally, price volatility is related positively to lagged small trader imbalances, supportive of noise trader effects, and negatively to the lagged variability of speculator imbalances, which is inconsistent with speculator activity promoting futures market volatility. Our results are broadly similar in extreme market conditions. The picture that emerges from our analysis is that speculators are risk averse, short-term oriented, liquidity providers with trades that are, in general, not destabilizing. Our work contributes to the debate on the effects of trading, especially by speculators, and the need for new regulatory initiatives.

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Cites background from "Market liquidity and funding liquid..."

...As speculative behavior is thought to be related to market instability (Brunnermeier and Pedersen, 2009) and systemic risk (Acharya and Naqvi, 2011), the dynamics of speculative trading are of interest to regulators and market participants in general....
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Posted Content•DOI•

Credit Rationing in Markets with Imperfect Information.

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Joseph E. Stiglitz, Andrew Weiss

01 Jan 1981-The American Economic Review

TL;DR: In this paper, a model is developed to provide the first theoretical justification for true credit rationing in a loan market, where the amount of the loan and amount of collateral demanded affect the behavior and distribution of borrowers, and interest rates serve as screening devices for evaluating risk.

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Abstract: According to basic economics, if demand exceeds supply, prices will rise, thus decreasing demand or increasing supply until demand and supply are in equilibrium; thus if prices do their job, rationing will not exist. However, credit rationing does exist. This paper demonstrates that even in equilibrium, credit rationing will exist in a loan market. Credit rationing is defined as occurring either (a) among loan applicants who appear identical, and some do and do not receive loans, even though the rejected applicants would pay higher interest rates; or (b) there are groups who, with a given credit supply, cannot obtain loans at any rate, even though with larger credit supply they would. A model is developed to provide the first theoretical justification for true credit rationing. The amount of the loan and the amount of collateral demanded affect the behavior and distribution of borrowers. Consequently, faced with increased credit demand, it may not be profitable to raise interest rates or collateral; instead banks deny loans to borrowers who are observationally indistinguishable from those receiving loans. It is not argued that credit rationing always occurs, but that it occurs under plausible assumptions about lender and borrower behavior. In the model, interest rates serve as screening devices for evaluating risk. Interest rates change the behavior (serve as incentive mechanism) for the borrower, increasing the relative attractiveness of riskier projects; banks ration credit, rather than increase rates when there is excess demand. Banks are shown not to increase collateral as a means of allocating credit; although collateral may have incentivizing effects, it may have adverse selection effects. Equity, nonlinear payment schedules, and contingency contracts may be introduced and yet there still may be rationing. The law of supply and demand is thus a result generated by specific assumptions and is model specific; credit rationing does exist. (TNM)

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13,126 citations

"Market liquidity and funding liquid..." refers background in this paper

...…private information (Kyle (1985) and Glosten and Milgrom (1985)), inventory risk of market makers (e.g. Stoll (1978), Ho and Stoll (1981,1983) Ho and Stoll (1981) and Grossman and Miller (1988)), search frictions (Duffie, Gârleanu, and Pedersen (2003, 2003a)), or predatory trading…...
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...…order processing costs, private information (Kyle (1985) and Glosten and Milgrom (1985)), inventory risk of market makers (e.g. Stoll (1978), Ho and Stoll (1981,1983) Ho and Stoll (1981) and Grossman and Miller (1988)), search frictions (Duffie, Gârleanu, and Pedersen (2003, 2003a)), or…...
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Journal Article•DOI•

Continuous Auctions and Insider Trading

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Albert S. Kyle

01 Nov 1985-Econometrica

9,341 citations

"Market liquidity and funding liquid..." refers background in this paper

...A bank’s capital W consists of equity capital plus its long-term borrowings (including credit lines secured from individual or syndicates of commercial banks), reduced by assets that cannot be readily employed (e.g. goodwill, intangible assets, property, equipment, and capital needed for daily…...
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...…a security can be costly to trade — that is, has less than perfect market liquidity — because of exogenous order processing costs, private information (Kyle (1985) and Glosten and Milgrom (1985)), inventory risk of market makers (e.g. Stoll (1978), Ho and Stoll (1981,1983) Ho and Stoll (1981) and…...
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Journal Article•DOI•

Bank Runs, Deposit Insurance, and Liquidity

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Douglas W. Diamond, Philip H. Dybvig

01 Jun 1983-Journal of Political Economy

TL;DR: The authors showed that bank deposit contracts can provide allocations superior to those of exchange markets, offering an explanation of how banks subject to runs can attract deposits, and showed that there are circumstances when government provision of deposit insurance can produce superior contracts.

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Abstract: This paper shows that bank deposit contracts can provide allocations superior to those of exchange markets, offering an explanation of how banks subject to runs can attract deposits. Investors face privately observed risks which lead to a demand for liquidity. Traditional demand deposit contracts which provide liquidity have multiple equilibria, one of which is a bank run. Bank runs in the model cause real economic damage, rather than simply reflecting other problems. Contracts which can prevent runs are studied, and the analysis shows that there are circumstances when government provision of deposit insurance can produce superior contracts.

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9,099 citations

"Market liquidity and funding liquid..." refers background or result in this paper

...Most of the banking literature follows Diamond and Dybvig (1983) in assuming an exogenous liquidation technology — that is, market liquidity is not endogenized....
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...However, as Bryant (1980) and Diamond and Dybvig (1983) show, banks are subject to bank-runs if they offer demand deposit contracts (and markets are incomplete)....
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...Gromb and Vayanos (2002) derive welfare results in a model in which arbitrageurs face margin constraints similar to those in our model....
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Book•

The econometrics of financial markets

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John Y. Campbell¹, Andrew W. Lo¹, A. Craig MacKinlay¹•Institutions (1)

Princeton University¹

01 Jan 1997

TL;DR: In this paper, Campbell, Lo, and MacKinlay present an attempt by three well-known and well-respected scholars to fill an acknowledged void in the empirical finance literature, a text covering the burgeoning field of empirical finance.

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Abstract: This book is an ambitious effort by three well-known and well-respected scholars to fill an acknowledged void in the literature—a text covering the burgeoning field of empirical finance. As the authors note in the preface, there are several excellent books covering financial theory at a level suitable for a Ph.D. class or as a reference for academics and practitioners, but there is little or nothing similar that covers econometric methods and applications. Perhaps the closest existing text is the recent addition to the Wiley Series in Financial and Quantitative Analysis. written by Cuthbertson (1996). The major difference between the books is that Cuthbertson focuses exclusively on asset pricing in the stock, bond, and foreign exchange markets, whereas Campbell, Lo, and MacKinlay (henceforth CLM) consider empirical applications throughout the field of finance, including corporate finance, derivatives markets, and market microstructure. The level of anticipation preceding publication can be partly measured by the fact that at least three reviews (including this one) have appeared since the book arrived. Moreover, in their reviews, both Harvey (1998) and Tiso (1998) comment on the need for such a text, a sentiment that has been echoed by numerous finance academics.

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7,169 citations

"Market liquidity and funding liquid..." refers background in this paper

...Empirically, fundamental volatility can be captured using price changes over a longer time period, and the total fundamental and liquidity-based volatility is captured by short-term price changes as in the literature on variance ratios (see e.g. Campbell, Lo, and MacKinlay (1997) )....
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Journal Article•DOI•

Bid, ask and transaction prices in a specialist market with heterogeneously informed traders

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Lawrence R. Glosten¹, Lawrence R. Glosten², Paul Milgrom³•Institutions (3)

Northwestern University¹, University of Chicago², Yale University³

01 Mar 1985-Journal of Financial Economics

TL;DR: The presence of traders with superior information leads to a positive bid-ask spread even when the specialist is risk-neutral and makes zero expected profits as discussed by the authors, and the expectation of the average spread squared times volume is bounded by a number that is independent of insider activity.

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5,902 citations

"Market liquidity and funding liquid..." refers background in this paper

...…be costly to trade — that is, has less than perfect market liquidity — because of exogenous order processing costs, private information (Kyle (1985) and Glosten and Milgrom (1985)), inventory risk of market makers (e.g. Stoll (1978), Ho and Stoll (1981,1983) Ho and Stoll (1981) and Grossman and…...
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...Holmström and Tirole’s (1998, 2001) research focuses primarily on funding liquidity. They show that corporations with agency problems have a preference for government bonds because they provide a cushion for future funding liquidity problems. Hence, government bonds trade at a premium. Our paper is also related to parts of the literature on the “limits to arbitrage.”(17) Shleifer and Vishny (1997) show, among other things, that a demand shock can be amplified if losses lead to withdrawal of capital from fund managers. We show that a similar effect can arise due to leverage and document how the multiplier is exacerbated by the degree of leverage (Proposition 2) and that this funding effect can lead to fragility (Proposition 1). Liu and Longstaff (2004) derive the optimal dynamic arbitrage strategy under funding constraints in a setting with an exogenous price process....
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...Holmström and Tirole’s (1998, 2001) research focuses primarily on funding liquidity. They show that corporations with agency problems have a preference for government bonds because they provide a cushion for future funding liquidity problems. Hence, government bonds trade at a premium. Our paper is also related to parts of the literature on the “limits to arbitrage.”(17) Shleifer and Vishny (1997) show, among other things, that a demand shock can be amplified if losses lead to withdrawal of capital from fund managers....
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