Market Liquidity and Funding Liquidity

We provide a model that links an asset’s market liquidity (i.e., the ease with which it is traded) and traders ’ funding liquidity (i.e., the ease with which they can obtain funding). Traders provide market liquidity, and their ability to do so depends on their availability of funding. Conversely, traders ’ funding, i.e., their capital and margin requirements, de-pends on the assets ’ market liquidity. We show that, under certain conditions, margins are destabilizing and market liquidity and funding liquidity are mutually reinforcing, leading to liquidity spirals. The model explains the empirically documented features that market liquidity (i) can suddenly dry up, (ii) has commonality across securities, (iii) is related to volatility, (iv) is subject to “flight to quality, ” and (v) co-moves with the market. The model provides new testable predictions, including that speculators ’ capital is a driver of market liquidity and risk premiums. Trading requires capital. When a trader (e.g., a dealer, hedge fund, or invest-ment bank) buys a security, he can use the security as collateral and borrow against it, but he cannot borrow the entire price. The difference between the security’s price and collateral value, denoted as the margin or haircut, must b