Funding liquidity is the ability to raise money. Market liquidity, on the other side, is the ability to quickly buy or sell assets in volume without moving prices. Some assets are more liquid than others. A liquid market is a market with a continuous price, which might be fluctuating but there’s no hops. Where does the market liquidity come from? Dealers.

Take a supermarket as an example, the prices of goods in it are the same in the morning and in the evening. There’s a lot of supply and not much demand in the morning, and yet prices don’t fall. There’s a lot of demand and not much supply in the evening, and yet prices don’t rise. What are they doing that allows price to be continuous overtime? The secret is inventories. Inventories absorb he flow of demand. There is whole hierarchy of inventories that is lying behind the ability of a supermarket to make liquid markets.

One-sided dealers are buying whole sale and selling retail. There is a kind of security dealer that does this too, investment bank acts as a one sided dealer, meaning, they buy the whole thing and then they distribute it.

Two-sided dealers make a two-sided market for a security (a particular bond, stock, etc). They are willing to trade the security for money, and they are willing to trade money for security. A two-sided dealer needs two inventories:

  • inventories of cash
  • inventories of securities

Security Dealers and Liquid Security Markets

If any increase in one inventory is matched by a decrease in another, what would be the effect on the price of securities? The effect would be balance sheet changes, not price changes. Dealers are smoothers. I said if they have enough inventories here, they could conceivably just make the price flat. Not only do they make the price flat, but they make the the waiting time into infinitesimal.

In contrast, in a broker market, say a house market, there is no dealer, you have both the time problem, and the price problem. Dealers are supplying market liquidity and not doing it for free.

The Treynor’s Model

In the Treynor’s model, a dealer has:

  • a maximum short position (negative quantity of securities). If price goes up, you lose; if price goes down, you win.
  • a maximum long position (positive quantity of securities). If price goes up, you win; if price goes down, you lose.

The positions come from the capital that dealer has; the ability to borrow, or the sense of risk. Zero inventory position means the movement of the price of the security isn’t going to affect you at all.

VB ask →|      ↘︎                                    |         \
        |      ↘︎       ↘︎ - sell (inside spread)     |          outside
        |              ↘︎ - buy    ↘︎                 |          spread
        |                         ↘︎      ↘︎          |          /
        |                                ↘︎          |← VB bid /
        |                                           |
        short                 0                  long
                         price risk

Behind the scenes there are fundamental forces of supply and demand, so that

  1. When the price gets too low, there will be somebody steps up and says now I’m ready to buy. That’s the value-based bid.
  2. When the price goes too high, there will be somebody short this.

The dealers are making markets in between that spread. Dealers know somebody will finally buy at the value-based bid position, dealers sell to them, who is actually the liquidity provider of last resort for the dealer. The dealer is making markets inside that spread and his business is being supported by the existence of this outside spread.

If dealer didn’t know that he could get rid of an inventory, he would be much less likely to take the inventory, to let the inventory build up. And, and therefore would be much less likely to supply market liquidity.

Inside spread or dealer spread is what you actually see in the market. You’re not going to see the outside spread unless the inventories make you hit it.

This model is suggesting to you that, at least, security dealers are taking funding liquidity from banks and using it as a way to sell market liquidity, they are suppliers of market liquidity, they are demanders of funding liquidity.

Leverage refers to the ratio of your debt to your equity, or the ratio of your borrowed funds to your capital.

Leverage = Debt / Equity = Borrowed funds / Capital

The dealers are both long and short. In doing this, there are arbitrage, transporting liquidity from one market to another. Arbitrage links together all markets. One idealization of financial markets, is to imagine that it’s possible to arbitrage any slight difference in price.

Notice that, in the Treynor’s model, the price is moving around, depending on the dealer inventory, not depending on the fundamental value of the asset. The dealer is worried that you might know something that they don’t know, and that’s why they’re lowering the price. But they don’t know that you know something that they don’t know. All they know is that they have big inventories, and they don’t like that. And so they lower the price.

So Treynor’s model is a model in which the provision of liquidity to the market moves prices away from their fundamental values. Anytime the dealer has an inventory, the price is wrong. Your ability to trade, comes from the fact that you’re trading at the wrong price.

In a world with perfect arbitrage and complete liquidity as usually assumed in financial theory, the outside spread would be very narrow, and there would be no room and no need for dealers. However that is not the world where we live in.

In the real world where we are living in, liquidity is not a free good, it is provided for a profit by dealers, and it fluctuates, moves asset price around.

Banks and the Market for Liquidity

In the concept of the hierarchy of money and credit, security dealers are pretty far down from the best money in the world. If we want to ascend the hierarchy, we will start talking about banks.

Banks are facing different challenges than the security dealers. In the hierarchy of money and credit, banks are connecting layers of currency and deposits, and the price that is relevant between them is par, i.e. price of one. Currency and deposits trade one for one, there is no bid-ask spread. So, how can banks possibly make a market without moving the price and even be profitable from it?

First let’s recall the Treynor’s model, which focuses the net position of the dealer. However to understand banking, we need to do a little Gestalt switch and focus also on the gross position, which is larger. From the stylized balance sheet that divides the dealer’s balance sheet into two pieces, for example:

Matched bookSecurities-in $100Securities-out $100
Speculative book (Treynor’ model)Net financing $10Loans $10

From the example balance sheet above:

  1. The matched book part is comprised, in principle, of equal and opposite long and short positions.
  2. The matched book ensures that the fluctuation in security prices have exactly offsetting effects.
  3. Only the speculative book is exposed to price movement, and it is an order of magnitude smaller than the matched book.

Banks as a money dealer actually have two kinds of risk exposed in the speculative book:

Price riskFor example, bonds that are financed in the term repo market.
This is what the Treynor’s model focuses.
Liquidity riskFor example, borrowing short (say, overnight deposits) and lending long (say, loans for a month or longer time).
Money dealers have to roll the deposits everyday, which could be a run on the bank.

Adapt Treynor’s Model to Liquidity Risk

On the horizontal, instead of price risk that comes from inventories, we are going to have liquidity risk. The important thing is the spread between the overnight rate (usually being fixed by the Fed) and the term rate. The bid-ask spread will be upwards slopping. The dealers are quoting yields in the money markets, depending on their current exposure.

term   →|                                    ↗︎      |
rate    |                    bid - ↗︎         ↗︎      |
        |             ↗︎    offer - ↗︎                |
        |       ↗︎     ↗︎                             |
        |       ↗︎                                   |
        |                                           |
        short                 0                  long
                        liquidity risk

This graph, what this dealer model applied to money market is that if dealers are going to be willing to take on an additional liquidity risk, they have to be paid. And, what they’re paid is this spread between the term interest rate and the overnight rate – their profit.

That’s thinking of a bank, as a kind of security dealer, except the securities they’re dealing in is money. The other side of a bank, is the payment system. Banks are both involved in the payment system and in the money market.

The Modern Banking System

In the past, the understanding of banking system is roughly something like this:


Banking system



However the world has changed a lot: loans and deposits in the traditional banking systems are both dead. The modern banking system is a capital market based credit system, not a bank loan based system.

  1. Death of loans. Top corporate customers have access to open market credit, particularly commercial paper, where they can borrow more cheaply than banks.
  2. Death of deposits. Money market mutual funds began to offer depositors interest on their deposits, and became competitors of banks.
  3. Disintermediation occurred as ultimate borrowers and lenders began to take interest rate risk, without the bank standing between them. This is crucial in the emergence of a parallel banking system.
Finance companies

Money market mutual funds

LoansCommercial paperCommercial paperMMMF shares

Shadow banks


MortgageRMBSMM funding

MMMFs shares
ABCP = Assets based commercial paper

In capital market based system, the key prices are both determined in dealer markets.

The Fed in the Fed Funds Market

The thing that the Fed does, is to create an outside spread, meanwhile in normal time, the Fed also tries to stabilize the Fed Funds rate (over night rate). Here’s the Fed funds market from the point of view of a bank that might be dealing in the Fed funds market.

over    |                                    ↗︎      |← discount  \
night   |                       ↗︎            ↗︎      |  rate       outside
rate    |             ↗︎ - - - - ↗︎ - - - - - - - - - |← Fed funds   spread
        |       ↗︎     ↗︎                             |  rate       /
        |       ↗︎                                   |            /
  IOER →|                                           |           /
    elasticity                0                  discipline
                      settlement risk

The Fed is now paying interest 0.25% on excess reserves (IOER), putting a floor on the Fed funds rate. The Fed also puts a ceiling, the discount rate at which the Fed is willing to lend to banks is 0.75%. The Fed is making the outside spread, in the Fed funds market, pretty clearly.

Fed makes an outside spread but then they try to stabilize, they have a target Fed funds rate. Before the crisis the Fed made a spread, that the discount rate is 100 basis points over the Fed funds target rate. When the market by itself is pushing the Fed funds rate above the target, the Fed wants to add reserves. The way they do that is by lending to the market through treasury repo (called temporary open market operations).

How do banks manage to make markets in currency and deposits at a zero bid-ask spread and a price that is fixed at par, and how do they make profit doing so? The answer is that they are also in a complementary business, the business of hearing liquidity risk by issuing demand liabilities and investing the funds at term, and this business is highly profitable. They can not change the price of deposits in terms of currency, but they can:

  1. expand and contract the quantity of deposits because deposits are their own liability
  2. expand and contract the quantity of currency because of their access to the discount window at the Fed.

Security dealers are stuck with:

  • the quantity of securities out there
  • the quantity of cash out there.

However banks are not stuck with the quantity of deposits or currency, so although they have less flexibility on price, the are more flexible on quantity.

The Taylor Rule

Before the crisis in 2007, among pretty much all economists, the consensus of what the Fed should be doing is something called the Taylor Rule. It means that the Fed should be moving the Fed funds rate in accordance with an equation of the following form:

R = ρ + πe + α (πe - π*) + β (Y - YF)

R : target interest rate
ρ : natural rate of interest
πe : expected inflation
π* : inflation target
Y : output
YF : full employment target

The first part of the formulation R = ρ + πe is also called Fisher Effect. The idea’s just that the nominal interest rate is equal to the real interest rate plus expected inflation. This is what the market will do on its own – if you expect higher inflation, it’s only fair that creditors get more returns, so the nominal interest rate goes up.

The second part is a positive description of what the Fed are doing in order to correct the market. The term (πe - π*) is about prices, and the term (Y - YF) is about output. If you run the regression, you are actually calculating α and β.

In order to “Leaning against the wind” (tighter monetary policy for financial-stability purposes), α has to be greater than 1. If expected inflation πe is greater than the inflation target π*, we raise the nominal interest rate by more than the difference, to try to really create more discipline in the economy.

If output Y is below full employment YF, and β is the sensitivity of monetary policy to that, we lower interest rate to try to get some more elasticity.

Monetary Transmission Mechanism

When we are talking about the monetary transmission mechanism for monetary policy, we are going to revisit all diagrams above. There is a transmission mechanism from the overnight Fed Funds rate, to the term interest rate, to asset price.

The Fed is fixing a target Fed funds rate, the trading in the market leads to a level of discipline (on the right side of horizontal line) or elasticity (on the left side). The Fed in choosing its Fed funds target is trying to choose how much it wants to lean towards making things a little more elastic or disciplined. That’s a policy choice.

  1. If the Fed wants to raise the Fed funds rate, it shifts the target rate and also the discount rate.
  2. That will narrow the gap between the Fed funds rate and term rate, which the dealers aren’t happy with.
  3. So the dealers will raise the term interest rate, which will pushes upwards pressure on the term interest rate.
  4. That makes funding more expensive, so bond dealers don’t want to quite hold as a large inventory. So that will puts downward pressure on bond prices, leading to lower asset prices.
  5. Those asset prices then influence the price of loans.

Anatomy of a Crisis

Crisis is a kind of market imbalance that might conceivably happen every day. Consider an example including household sector, dealers, banks and the Fed. Suppose now households shifted their risk preferences, they don’t want to hold securities any more, they want to hold money (deposits) instead. Normally, the dealer system absorbs the imbalances in order flow:

  1. Household don’t want to hold securities, they want to hold deposits (money from their perspective).
  2. Dealers buy those securities, and use them as collateral to issue repurchase agreement which is bought by banks.




The dealers are giving the households the impression that they’ve sold their securities. But in fact they haven’t really, they’ve just been absorbed by the banking system. Dealers and banks are making money in the following way:

  • Dealers, in order to acquire these additional securities, are going to lower the price at which they acquire them. This will cause the sudden drop of the price of assets. Hopefully the price will come back later and the flow is reversed, the dealers make a profit.
  • For the banks, facing sudden more lending demands and more liquidity risk, they will lend at a little higher rate. Banks will make money later when the rate drops and banks liquidate their positions.

These (the price and the rate) are only the distortion away from the fundamental value. These are distorted prices and rates but they’re causing action, they’re putting pressure on the system by creating incentives to do something different.

When Serious Crisis Happens

What if there is a really big shock? It starts to move the dealers and banks into a position where they are anxious about. The Fed can come into play. Bank can lend more to the dealers, help the dealers by borrowing reserves for itself from the Fed. The central bank becomes the lender of last resort. If the Fed is willing to back-stop the banks, the banks are more willing to back-stop the dealers.






In essence, Fed is backstopping the short positions that the bank has in money, the liquidity risk that banks are taking on by having short positions in money themselves. The Fed’s creating more money by short positions. However the Fed can’t run into trouble with, because it’s the ultimate money, at least domestically. That’s why the Fed is able to relieve a crisis. The crisis is essentially everyone (household) wants money, they don’t want securities.

These securities have to go somewhere and the way that the lender of last resort works is that

  • the securities, that people don’t want, get absorbed into the financial sector
  • the cash, that people do want gets created, by the financial sector, and used to fund the positions in the security.

For more on Banking as Market Making, please refer to the wonderful course here

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