Market Liquidity and Funding Liquidity
Markus K. Brunnermeier, Lasse Heje Pedersen
Title, authors, journals (Only these sections are summarized: 1, 6, 7)
Title: Market Liquidity and Funding Liquidity
Authors: Markus K. Brunnermeier, Lasse Heje Pedersen
Journal: The Review of Financial Studies
Research Question + underlying intuition
This article provides a model that links an asset´s market liquidity with the trading funding liquidity.
Traders provide market liquidity, and their ability to do so depends on their availability of funding. On
the other hand, their fundings and the margins that they are charged depend on the asset´s market
liquidity, leading to a kind of spiral.
- Specifically, the authors show that under certain conditions, margins are destabilizing and
market liquidity and funding liquidity are mutually reinforcing, leading to liquidity spirals.
Their 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) co-moves with the market.
Trading requires capital. When a trader (e.g., a dealer, hedge fund, or investment bank) buys a
security, he can use the security as collateral and borrow against it, but he cannot borrow the entire
price. The difference between the security’s price and collateral value, denoted as the margin or
haircut, must be financed with the trader’s own capital. Similarly, short-selling requires capital in the
form of a margin; it does not free up capital. Therefore, the total margin on all positions cannot
exceed a trader’s capital at any time. The model shows that the funding of traders affects—and is
affected by— market liquidity in a profound way. When funding liquidity is tight, traders become
reluctant to take on positions, especially “capital intensive” positions in high-margin securities.
This lowers market liquidity, leading to higher volatility.
, Further, under certain conditions, low future market liquidity increases the risk of financing a
trade, thus increasing margins.
Based on the links between funding and market liquidity, this article provides a unified explanation
for the main empirical features of market liquidity.
- In particular, the model implies that market liquidity
(vi) can suddenly dry up,
(vii) has commonality across securities,
(viii) is related to volatility,
(ix) is subject to “flight to quality,” and
(x) co-moves with the market.
The model has several new testable implications that link margins and dealer funding to market
liquidity:
The authors predict that:
(i) speculators’ (mark-to-market) capital and volatility (as, e.g., measured by VIX) are
state variables affecting market liquidity and risk premiums;
(ii) a reduction in capital reduces market liquidity, especially if capital is already low (a
nonlinear effect) and for high-margin securities;
(iii) margins increase in illiquidity if the fundamental value is difficult to determine; and
(iv) speculators’ returns are negatively skewed (even if they trade securities without
skewness in the fundamentals).
The authors define market liquidity as the difference between the transaction price and the
fundamental value, and funding liquidity as speculators’ scarcity (or shadow cost) of capital.
Property of margins
- We first analyze the properties of margins, which determine the investors’ capital
requirement.
- We show that margins can increase in illiquidity when margin-setting financiers are unsure
whether price changes are due to fundamental news or to liquidity shocks, and volatility is
time varying.
- This happens when a liquidity shock leads to price volatility, which raises the financier’s
expectation about future volatility, and this leads to increased margins.
