Market liquidity and funding liquidity

Markus K. Brunnermeier, Lasse Heje Pedersen

Research output: Contribution to journalArticle

1402 Scopus citations

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 margin requirements, depends 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) co-moves with the market. The model provides new testable predictions, including that speculators' capital is a driver of market liquidity and risk premiums.

Original languageEnglish (US)
Pages (from-to)2201-2238
Number of pages38
JournalReview of Financial Studies
Volume22
Issue number6
DOIs
StatePublished - Jun 2009

All Science Journal Classification (ASJC) codes

  • Accounting
  • Finance
  • Economics and Econometrics

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