DP6179 Market Liquidity and Funding Liquidity

Author(s): Markus K Brunnermeier , Lasse Heje Pedersen

Publication Date: March 2007

Keyword(s): counterparty credit risk , leverage , liquidity risk management , margins , systemic risk , value-at-risk

JEL(s): G1 , G2

Programme Areas: Financial Economics , International Macroeconomics

Link to this Page: www.cepr.org/pubs/dps/DP6179.asp.asp

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.