RFS Advance Access first published online on November 26, 2008
This version published online on December 10, 2008
Review of Financial Studies, doi:10.1093/rfs/hhn098
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Market Liquidity and Funding Liquidity
Princeton University
New York University
Send correspondence to Markus K. Brunnermeier, Princeton University, NBER and CEPR, Department of Economics, Bendheim Center for Finance, Princeton University, 26 Prospect Avenue, Princeton, NJ 08540-5296. E-mail: markus{at}princeton.edu.
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Abstract |
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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.
We are grateful for helpful comments from Tobias Adrian, Franklin Allen, Yakov Amihud, David Blair, Bernard Dumas, Denis Gromb, Charles Johns, Christian Julliard, John Kambhu, Markus Konz, Stefan Nagel, Michael Brennan, Martin Oehmke, Ketan Patel, Guillaume Plantin, Felipe Schwartzman, Hyun Shin, Matt Spiegel (the editor), Jeremy Stein, Dimitri Vayanos, Jiang Wang, Pierre-Olivier Weill, and from an anonymous referee and Filippos Papakonstantinou and Felipe Schwartzman for outstanding research assistantship. We also thank seminar participants at the New York Federal Reserve Bank, the New York Stock Exchange, Citigroup, Bank for International Settlement, University of Zürich, INSEAD, Northwestern University, Stockholm Institute for Financial Research, Goldman Sachs, IMF, the World Bank, UCLA, LSE, Warwick University, Bank of England, University of Chicago, Texas A&M, University of Notre Dame, HEC, University of Maryland, University of Michigan, Virginia Tech, Ohio State University, University of Mannheim, ECB-Bundesbank, MIT, and conference participants at the American Economic Association Meeting, FMRC conference in honor of Hans Stoll at Vanderbilt, NBER Market Microstructure Meetings, NBER Asset Pricing Meetings, NBER Risks of Financial Institutions conference, the Five Star conference, and American Finance Association Meeting. Brunnermeier acknowledges financial support from the Alfred P. Sloan Foundation.