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Constrained liquidity provision in currency markets

Author

Listed:
  • Huang, Wenqian
  • Ranaldo, Angelo
  • Schrimpf, Andreas
  • Somogyi, Fabricius

Abstract

We devise a simple model of liquidity demand and supply to study dealers’ liquidity provision in currency markets. Drawing on a globally representative data set of currency trading volumes, we show that at times when dealers’ intermediation capacity is constrained the cost of liquidity provision increases disproportionately relative to dealer-intermediated volume. Consequently, the otherwise strong and positive relation between liquidity costs and trading volume diminishes significantly when dealers face tighter Value-at-Risk limits or higher funding costs. Using various econometric approaches, we show that this nonlinear effect of dealer constraints on market liquidity primarily stems from a reduction in the elasticity of liquidity supply, rather than changes in liquidity demand.

Suggested Citation

  • Huang, Wenqian & Ranaldo, Angelo & Schrimpf, Andreas & Somogyi, Fabricius, 2025. "Constrained liquidity provision in currency markets," Journal of Financial Economics, Elsevier, vol. 167(C).
    • Handle: RePEc:eee:jfinec:v:167:y:2025:i:c:s0304405x25000364
    DOI: 10.1016/j.jfineco.2025.104028
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    More about this item

    Keywords

    Currency markets; Dealer constraints; Market liquidity; FX; Liquidity provision;
    All these keywords.

    JEL classification:

    • F31 - International Economics - - International Finance - - - Foreign Exchange
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G15 - Financial Economics - - General Financial Markets - - - International Financial Markets

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