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We examine the economic mechanisms that limited arbitrage between the cash and forward markets of agency MBS, and whether asset purchases of the Federal Reserve

The Term Auction Facility (TAF), the first auction-based liquidity initiative by the Federal Reserve during the global financial crisis, was aimed at improving conditions in the dollar money market and bringing down the significantly elevated London interbank offered rate (Libor). The effectiveness of this innovative policy tool is crucial for understanding the role of the central bank in financial stability, but academic studies disagree on the empirical evidence of the TAF effect on Libor. We show that the disagreement arises from mis-specifications of econometric models. Regressions using the daily level of the Libor-OIS spread as the dependent variable miss either the permanent or temporary TAF effect, depending on whether the dummy variable indicates the events of the TAF or the regimes before and after an TAF event. Those regressions also suffer from the unit-root problem and produce unreliable test statistics. By contrast, regressions using the daily change in the Libor-OIS spread are robust to the persistence of the TAF effect and the unit-root problem, consistently producing reliable evidence that the downward shifts of the Libor-OIS spread were associated with the TAF. The evidence indicates the efficacy of the TAF in helping the interbank market to relieve liquidity strains.

We examine the financial conditions of dealers that participated in two of the Federal Reserve's lender-of-last-resort (LOLR) facilities—the Term Securities Lending Facility (TSLF) and the Primary Dealer Credit Facility (PDCF)—that provided liquidity against a range of assets during 2008–2009. Dealers with lower equity returns and greater leverage prior to borrowing from the facilities were more likely to participate in the programs, borrow more, and, in the case of the TSLF, at higher bidding rates. Dealers with less liquid collateral on their balance sheets before the facilities were introduced also tended to borrow more. The results suggest that both financial performance and balance sheet liquidity play a role in LOLR utilization.

We examine sources of systemic risk (threshold size, complexity, and interconnectedness) with factors constructed from equity returns of large financial firms, after accounting for standard risk factors. From the factor loadings and factor returns, we estimate the implicit government subsidy for each systemic risk measure, and find that, from 1963 to 2006, only our big-versus-huge threshold size factor, TSIZE, implies a positive implicit subsidy on average. Further, pre-2007 TSIZE-implied subsidies predict the Federal Reserve’s liquidity facility loans and the Treasury’s TARP loans during the crisis, both in the time series and the cross section. TSIZE-implied subsidies increase around the bailout of Continental Illinois in 1984 and the Gramm-Leach-Bliley Act of 1999, as well as around changes in Fitch Support Ratings indicating higher probability of government support. Since 2007, however, the relative share of TSIZE-implied subsidies falls, especially after Lehman’s failure, whereas complexity and interconnectedness-implied subsidies are substantial, resulting in an almost sevenfold increase in total implicit subsidies. The results, which survive a variety of robustness checks, indicate that the market’s perception of the sources of systemic risk changes over time.

We find that banks subject to the Liquidity Coverage Ratio (LCR) create less liquidity per dollar of assets in the post-LCR period than banks not subject to the LCR, in part because LCR banks make fewer loans. However, we also find that LCR banks are more resilient, as they contribute less to fire-sale risk relative to non-LCR banks. For large banks, we estimate the net after-tax benefits from reduced lending and fire-sale risk to be about 1.4 percent of assets from second-quarter 2013 through fourth-quarter 2014. Our findings, which we show are unlikely to result from capital regulations, highlight the trade-off between lower liquidity creation and greater resilience from liquidity regulations.

We provide empirical evidence for the existence, magnitude, and economic cost of stigma associated with banks borrowing from the Federal Reserve's Discount Window (DW) during the 2007–2008 financial crisis. We find that banks were willing to pay a premium of around 44 basis points (bps) across funding sources (126 bps after the bankruptcy of Lehman Brothers) to avoid borrowing from the DW. DW stigma is economically relevant as it increased some banks' borrowing cost by 32 bps of their pre-tax return on assets (ROA) during the crisis. The implications of our results for the provision of liquidity by central banks are discussed.

This paper examines the relation between information transmission and cross-autocorrelations. We present a simple model, where informed trading is transmitted from large to small stocks with a lag. In equilibrium, large stock illiquidity induced by informed trading portends stronger cross-autocorrelations. Empirically, we find that the lead-lag relation increases with lagged large stock illiquidity. Further, the lead from large stock order flows to small stock returns is stronger when large stock spreads are higher. In addition, this lead-lag relation is stronger before macro announcements (when information-based trading is more likely) and weaker afterward (when information asymmetries are lower).

In responding to the severity and broad scope of the financial crisis that began in 2007, the Federal Reserve has made aggressive use of both traditional monetary policy instruments and innovative tools in an effort to provide liquidity. In this paper, I examine the Fed’s actions in light of the underlying financial amplification mechanisms propagating the crisis — in particular, balance sheet constraints and counterparty credit risk. The empirical evidence supports the Fed’s views on the primacy of balance sheet constraints in the earlier stages of the crisis and the increased prominence of counterparty credit risk as the crisis evolved in 2008. I conclude that an understanding of the prevailing risk environment is necessary in order to evaluate when central bank programs are likely to be effective and under what conditions the programs might cease to be necessary.

We examine the financial conditions of dealers that participated in two of the Federal Reserve’s lender-of-last-resort (LOLR) facilities -- the Term Securities Lending Facility (TSLF) and the Primary Dealer Credit Facility (PDCF) -- that provided liquidity against a range of assets during 2008-09. Dealers with lower equity returns and greater leverage prior to borrowing from the facilities were more likely to participate in the programs, borrow more, and--in the case of the TSLF -- at higher bidding rates. Dealers with less liquid collateral on their balance sheets before the facilities were introduced also tended to borrow more. There also appear to be some interaction effects between financial performance and balance sheet liquidity in explaining dealer behavior. The results suggest that both financial performance and balance sheet liquidity play a role in LOLR utilization.

This article examines the provision of liquidity in futures markets as price volatility changes. We find that customer trading costs do not increase with volatility. However, for three of the four contracts studied, the nature of liquidity supply changes with volatility. Specifically, for relatively inactive contracts, customers as a group trade more with each other and less with market makers, on higher volatility days. By contrast, for the most active contract, trading between customers and market makers increases with volatility. We also find that market makers' income per contract decreases with volatility for one of the least active contracts in our sample, but is not significantly affected by volatility for the other contracts. These results are consistent with the idea that, for high-cost, inactive contracts, market makers react to temporary increases in volatility by raising their bid-ask spreads significantly, and customers provide increased liquidity through standing limit orders. An implication of our results is that electronic systems, where market maker participation is not required, are able to supply adequate liquidity during volatile periods. © 2001 John Wiley & Sons, Inc. Jrl Fut Mark 21:1–17, 2001

JEL Classification numbers G12, G14, G15 In contrast to most other countries, Chinese foreign class B shares trade at an average discount of about 60 percent to the prices at which domestic A shares trade. We argue that one reason for the large price discount of B shares is because foreign investors have less information on Chinese stocks than domestic investors. We develop a model, incorporating both informational asymmetry and market segmentation, and derive a relative pricing equation for A shares and B shares. We show theoretically that an A share index security, tradable by foreigners, increases the liquidity of B shares. Our empirical study of Chinese stocks supports the predictions of our model. Specifically, we show that our model-based proxies for informational asymmetry explain a significant portion of the cross-sectional variation of the B share discounts.

Following the financial crisis of 2007, many global financial firms faced difficulties in borrowing U.S. dollars (USD). We estimate the premium global banks paid to obtain USD (the “USD basis”) by the rate banks pay to swap euros into USD in the foreign exchange (FX) market, while fully hedging the FX risk, relative to the interbank rate for borrowing USD. We find that the bank basis is higher the day following increases in CDS prices and in asymmetric information measures. Controlling for fundamental risk, the basis is lower the day after successful borrowing at the Fed’s dollar liquidity facilities and it is higher for European banks following an unanticipated decrease in repo funding amounts, implying that USD funding constraints were binding for European banks during the crisis. Our results show that increased asymmetric information and “repo runs” (through unanticipated withdrawals of repo funding) combined to increase bank funding costs during the crisis.

We provide empirical evidence for the existence, magnitude, and economic impact of stigma associated with discount window liquidity provision by the Federal Reserve. We find that during the height of the financial crisis banks were willing to pay a premium of at least 37 basis points (150 basis points after Lehman’s bankruptcy) on average to borrow from the Term Auction Facility (TAF) rather than from the discount window. The incidence of stigma varied with bank characteristics and market conditions. Finally, we find that discount window stigma is economically relevant since it increased banks’ borrowing costs during the crisis. Our results have important implications for the provision of liquidity by central banks.

This paper examines the mechanism by which the incorporation of information into prices leads to cross-autocorrelations in stock returns. We present a simple model where trading on private information occurs first in the large stocks and is transmitted to small stocks with a lag. Such trading impacts large stock liquidity, so that, in equilibrium, large stock illiquidity portends stronger cross-autocorrelations. Empirically, we find that the lead-lag relation between large and small stocks increases with lagged illiquidity indicators of large stocks. Further, order flows in large stocks significantly predict returns of small stocks when large stock spreads are high, at both the market and industry levels. In addition, the role of order flow and liquidity in predicting small stock returns is stronger prior to macro announcements (when information-based trading is more likely).

The small decline in the value of mortgage-related assets relative to the large total losses associated with the financial crisis suggests the presence of financial amplification mechanisms, which allow relatively small shocks to propagate through the financial system. We review the literature on financial amplification mechanisms and discuss the Federal Reserve’s interventions during different stages of the crisis in light of this literature. We interpret the Fed’s early-stage liquidity programs as working to dampen balance sheet amplifications arising from the positive feedback between financial constraints and asset prices. By comparison, the Fed’s later-stage crisis programs take into account adverse-selection amplifications that operate via increases in credit risk and the externality imposed by risky borrowers on safe ones. Finally, we provide new empirical evidence that increases in the Federal Reserve’s liquidity supply reduce interest rates during periods of high liquidity risk. Our analysis has implications for the impact on market prices of a potential withdrawal of liquidity supply by the Fed.

textabstractWe develop a new likelihood-based approach to sign trades in the absence of quotes. It is equally efficient as existing MCMC methods, but more than 10 times faster. It can deal with the occurrence of multiple trades at the same time, and noisily observed trade times. We apply this method to a high-frequency dataset of the 30Y U.S. treasury futures to investigate the role of the market maker. Most theory characterizes him as an uninformed passive liquidity supplier. Our results suggest that some market makers actively demand liquidity for a substantial part of the day and are informed speculators.

We examine how investor heterogeneity affects the relation between liquidity changes and yield spread changes, using newly-available trade data for more than 3,700 bonds of 635 issuers. We find that, for retail trades, liquidity is a significant determinant of yield spreads and adds substantially to the explanatory power of regressions, after accounting for issuer and market risk. Further, the impact of liquidity is inversely related to retail traders' expected holding period. In contrast, for institutional trades, liquidity and yield spreads are essentially unrelated at all holding periods. We further find, for retail traders, the return premia to holding illiquid bond portfolios is positive and concave in the expected holding period, as predicted by Amihud and Mendelson (1986). Moreover, retail traders earn greater return premia than institutions for the same holding period. Thus, the market at least partially compensates retail investors for the greater illiquidity of their bond trades. Our results point to the importance of investor heterogeneity for understanding the determinants of credit risk.

This article explores cross-market liquidity dynamics by estimating a vector autoregressive model for liquidity (bid-ask spread and depth, returns, volatility, and order flow in the stock and Treasury bond markets). Innovations to stock and bond market liquidity and volatility are significantly correlated, implying that common factors drive liquidity and volatility in these markets. Volatility shocks are informative in predicting shifts in liquidity. During crisis periods, monetary expansions are associated with increased liquidity. Moreover, money flows to government bond funds forecast bond market liquidity. The results establish a link between "macro" liquidity, or money flows, and "micro" or transactions liquidity. A number of important theorems in finance rely on the ability of investors to trade any amount of a security without affecting the price. However, there exist several frictions,1 such as trading costs, short sale restrictions, and circuit breakers, that impact price formation. The influence of market imperfections on security pricing has long been recognized. Liquidity, in particular, has attracted a lot of attention from traders, regulators

We study the joint time-series of daily liquidity in government bond and stock markets over the period 1991 to 1998. Innovations in liquidity are positively and significantly correlated across stock and bond markets. Further, order imbalances in the stock market impact bond and stock liquidity, even after controlling for order imbalances in the bond market. Both results suggest the existence of a common liquidity factor in stock and bond markets. We consider monetary conditions and mutual fund flows as sources of order flow and as primitive determinants of liquidity. Monetary expansion enhances stock market liquidity during crises. U.S. government bond funds see higher inflows and equity funds see higher outflows during financial crises, and these flows are associated with decreased liquidity in stock and bond markets. Our results establish a link between "macro" liquidity, or money flows, and "micro" or transactions liquidity.

Dual trading is the practice whereby futures floor traders execute trades both for their own and customers' accounts on the same day. We provide evidence, in the context of restrictions on dual trading, that aggregate liquidity measures, such as the average bid-ask spread, may be misleading indicators of traders' welfare in markets with multiple, heterogeneously skilled dealers. In our theoretical model, hedgers and informed customers trade through futures floor traders of different skill levels: more skilled floor traders attract more hedgers to trade. We show that customers' welfare and dual trader revenues are increasing in the skill level and, so, a restriction on dual trading is welfare-reducing for customers of dual traders with above-average skill levels. Yet, our results further show, the restriction may leave market depth unchanged if the difference in average skill levels between dual traders and pure brokers in not large. ; We empirically study two episodes of dual trading restrictions and find that dual traders were heterogeneous with respect to their personal trading skills. Further, although the average realized bid-ask spread was unchanged in both these episodes, restrictions may have hurt dual traders of above-average skills and their customers. Specifically, we find that dual traders with above-average skills may have quit brokerage and switched to trading for their own accounts following restrictions, as conjectured by Grossman (1989).

Hedgers and a risk-neutral informed trader choose between a broker who takes a position in the asset (a capital broker) and a broker who does not (a discount broker). The capital broker exploits order flow information to mimic informed trades and offset hedgers' trades, reducing informed profits and hedgers' utility. But the capital broker has a larger capacity to execute hedgers' orders, increasing market depth. In equilibrium, hedgers choose the broker with the lowest price per unit of utility while the informed trader chooses the broker with the lowest price per unit of the informed order flow. However, the chosen broker may not be the one with whom market depth and net order flow are higher. ; We relate traders' broker choice to market structure and show that the capital broker benefits customers relatively more in developed securities--i.e., markets where there are many hedgers with low levels of risk aversion and endowment risk, where the information precision is high and the asset volatility is low. The discount broker benefits customers relatively more in volatile markets where there are few hedgers with high levels of risk aversion and endowment volatility, and where information is imprecise. We derive testable predictions from our model and successfully explain up to 70 percent of the daily variation in the number of discount brokers and capital brokers (or, dual traders in futures markets).