Market Liquidity and Funding Liquidity

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Abstract
We provide a model that links a security's market liquidity --- i.e., the ease of trading it --- and traders' funding liquidity --- i.e., their availability of funds. Traders provide market liquidity and their ability to do so depends on their funding, that is, their capital and the margins charged by their financiers. In times of crisis, reductions in market liquidity and funding liquidity are mutually reinforcing, leading to a liquidity spiral. The model provides a natural explanation for the empirically documented features that market liquidity: (i) periodically dries up, (ii) has commonality across securities, (iii) is related to volatility, (iv) experiences flight to liquidity events, and (v) comoves with the market. Finally, the model shows how the Fed can improve current market liquidity by committing to improve funding in a potential future crisis.

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