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Market Liquidity and Funding Liquidity

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  • Lasse Heje Pederson
  • Markus K Brunnermeier

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

Suggested Citation

  • Lasse Heje Pederson & Markus K Brunnermeier, 2007. "Market Liquidity and Funding Liquidity," FMG Discussion Papers dp580, Financial Markets Group.
    • Handle: RePEc:fmg:fmgdps:dp580
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    References listed on IDEAS

    as
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    More about this item

    Keywords

    liquidity risk management; liquidity; liquidation; systemic risk; leverage; margins; haircuts; value-at-risk; counterparty credit risk;
    All these keywords.

    JEL classification:

    • G1 - Financial Economics - - General Financial Markets
    • G2 - Financial Economics - - Financial Institutions and Services

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