Dealer Funding and Market Liquidity
When a client wants to exit a position, dealers can provide immediacy by taking over the position.We consider a model in which dealers need to raise external nance to do so, and can subsequently exert unobservable effort to improve the chance of closing the positions that they take over at a profit. This moral hazard problem affects how and how much external finance dealers can raise. Therefore, it limits intermediation volume, soften competition between dealers, and widens bid-ask spreads. When dealers suffer losses, the problem becomes worse. Effects are stronger for riskier assets. Endogenous correlation and contagion in liquidity arise between otherwise unrelated assets. As the optimal financing arrangement involves debt, regulations that limits the leverage of bank-affiliated dealers can have adverse effects on market liquidity.