Leverage Constraints and Liquidity: What Can We Learn from Margin Trading?

Do traders’ leverage constraints drive equity market liquidity? We use the unique features of the margin trading system in India to test the hypothesis that there is a causal relationship between traders’ leverage constraints (i.e., their ability to borrow to invest in risky assets) and a stock’s market liquidity. In India, the list of stocks eligible for margin trading is revised every month, creating a series of quasi-experiments that provide traders of newly eligible and ineligible stocks with shocks to the availability of leverage. We employ a regression discontinuity design that exploits the threshold rules that determine a stock’s margin trading eligibility. When we compare the liquidity of eligible and ineligible stocks that lie close to the eligibility threshold, we find that liquidity is higher when stocks become eligible for margin trading and that it decreases with ineligibility. Using available data on margin financing activity at the individual stock level, we try to uncover the mechanisms driving this main finding. We find evidence consistent with the idea that the liquidity enhancement that we observe stems from margin traders’ contrarian strategies.