Trading requires capital. When a trader—e.g. a dealer, hedge fund, or investment 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 the margin, must be financed with the trader's own capital. Similarly, shortselling requires capital in the form of a margin; it does not free up capital. Hence, at anytime the total margins on all positions cannot exceed the trader's capital.
Our model shows that the funding of trades affects, and is affected by, market liquidity in a profound way. When funding liquidity is tight, traders become reluctant to take on positions, especially "capital intensive" positions in high-margin securities. This lowers market liquidity. Further, low future market liquidity increases the risk of financing a trade, thus increasing the margins.
Based on the links between funding and market liquidity, we provideaunified explanation for the main empirical features of market liquidity. In particular, the model implies that market liquidity (i) can suddenly dry up, (ii) has commonality across securities, (iii) is related to volatility, (iv) experiences "flight to liquidity" events, and (v) comoveswiththe market.
Our model is similar inspirit to Grossmanand Miller (1988) with the new feature that dealers face the real-world funding constraint discussed above. In our model, a group of "initial customers" face a supply shock at time one, which affects their willingness to hold shares. A group of "complementary customers" face the opposing shock, but these agents arrive in the market only at a later time. A group of dealers bridge the gap between the initial and complementary customers by smoothing the price and thus providing market liquidity.
