Dealer Funding and Market Liquidity

This working paper was written by Max Bruche (Humboldt University of Berlin) and John C.F. Kuong (INSEAD).We consider a model in which dealers intermediate trades between clients and provide immediacy, or, market liquidity. Dealers can exert unobservable 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. 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 the developments of intermediation in bond markets in response to post-crisis bank regulations