Constrained Dealers and Market Efficiency
Series
School of Finance Working Paper
Type
working paper
Date Issued
2021-11-04
Author(s)
Abstract
We analyse how constraints on dealers’ risk bearing capacity affect market efficiency in the foreign exchange (FX) market. Dealers support market efficiency by accommodating their customers’ trading
demands through elastic liquidity provision in normal times but when they face constraints their elasticity of liquidity provision weakens. Episodes of tight dealer constraints – for instance, due to
high leverage, Value-at-Risk, and funding costs – in turn go hand in hand with price inefficiencies due to law of one price deviations and elevated trading costs. We rationalise our novel empirical
findings with a tractable model that sheds light on the key mechanisms of how market efficiency can deteriorate when dealers are more constrained.
demands through elastic liquidity provision in normal times but when they face constraints their elasticity of liquidity provision weakens. Episodes of tight dealer constraints – for instance, due to
high leverage, Value-at-Risk, and funding costs – in turn go hand in hand with price inefficiencies due to law of one price deviations and elevated trading costs. We rationalise our novel empirical
findings with a tractable model that sheds light on the key mechanisms of how market efficiency can deteriorate when dealers are more constrained.
Language
English
Keywords
Market Efficiency
Dealer Constraints
Foreign Exchange
Liquidity Provision
HSG Classification
contribution to scientific community
HSG Profile Area
SOF - System-wide Risk in the Financial System
Publisher
SoF HSG
Volume
2021
Number
16
Pages
56
Subject(s)
Eprints ID
264743
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21_16_Huang_Ranaldo_Schrimpf_Somogyi_Constrained Dealers and Market Efficiency.pdf
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Format
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