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Constrained Liquidity Provision in Currency Markets

Author

Listed:
  • Wenqian Huang

    (Bank for International Settlements)

  • Angelo Ranaldo

    (University of St. Gallen; Swiss Finance Institute)

  • Andreas Schrimpf

    (CREATES - Aarhus University; Bank for International Settlements (BIS) - Monetary and Economic Department)

  • Fabricius Somogyi

    (D’Amore-McKim School of Business)

Abstract

We study dealers’ liquidity provision in the currency market. We show that at times when dealers’ intermediation capacity is constrained their cost of liquidity provision increases disproportionately relative to dealer-provided volume. As a result, the elasticity of dealers’ liquidity provision weakens by at least 80% relative to periods when they are unconstrained. We identify constrained periods based on leverage ratios, Value-at-Risk measures, credit default spreads, and debt funding costs. We interpret our novel empirical findings within a parsimonious model that sheds light on the key mechanisms of how liquidity provision by dealers tends to weaken when intermediary constraints are tightening.

Suggested Citation

  • Wenqian Huang & Angelo Ranaldo & Andreas Schrimpf & Fabricius Somogyi, 2022. "Constrained Liquidity Provision in Currency Markets," Swiss Finance Institute Research Paper Series 22-82, Swiss Finance Institute.
    • Handle: RePEc:chf:rpseri:rp2282
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    Keywords

    Currency markets; dealer constraints; market liquidity; foreign exchange; 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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