Market Liquidity and Funding Liquidity

Source: Brunnermeier, M. K. & Pedersen, L. H. (2009) · Review of Financial Studies 22(6), 2201–2238 · DOI: 10.1093/rfs/hhn098

The question

How are market liquidity (the ease of trading an asset) and funding liquidity (the ease with

which traders finance positions) connected, and why does market liquidity sometimes evaporate suddenly,

comove across assets, and dry up most for high-margin, volatile securities — as in the 2007–09 crisis?

Speculators provide market liquidity but are capital- and margin-constrained: the margin on

every long and short position must be financed out of own capital, so total margins cannot exceed a

trader's capital at any time.

Funding liquidity (capital and the margins charged) and market liquidity are **mutually

determined**: tighter funding makes speculators cut positions — especially capital-intensive,

high-margin ones — which widens spreads and raises volatility.

Higher volatility and lower future market liquidity raise margins ("margin spiral"), and

mark-to-market losses erode capital ("loss spiral"). Under stated conditions margins are

destabilizing, so the two liquidities are mutually reinforcing → liquidity spirals.

The model gives a unified explanation for documented features of market liquidity, predicting that it:

(i) can suddenly dry up; (ii) has commonality across securities; (iii) is **related to

volatility; (iv) is subject to flight to quality/liquidity; and (v) comoves with the market**.

New testable implications: a shock to speculator capital is a priced state variable; margins and dealer

funding drive market liquidity; and liquidity risk should carry a premium.

A core theoretical reference for liquidity crises and systemic risk. It rationalizes the empirical

commonality-in-liquidity and liquidity-risk-premium findings (Amihud; Pástor–Stambaugh; Acharya–

Pedersen) and closely fits the dynamics of the 2007–09 crisis.

A stylized equilibrium model; quantitative calibration to real markets is difficult.

Focuses on funding-constrained intermediaries; other liquidity frictions (asymmetric information,

search) are largely abstracted away.

Brunnermeier, M. & Pedersen, L. (2009) — Market Liquidity and Funding Liquidity — Review of Financial Studies

Amihud, Y. (2002) — Illiquidity and Stock Returns — Journal of Financial Markets

Pástor, Ľ. & Stambaugh, R. (2003) — Liquidity Risk and Expected Stock Returns — Journal of Political Economy

Provenance: verified/generated from the paper's full text.