Abstract
We analyse how constraints on dealers’ risk bearing capacity affect market efficiency in the foreign exchange (FX) market. Dealers support market efficiency by accommodating their customers’ trading demands through elastic liquidity provision in normal times but when they face constraints their elasticity of liquidity provision weakens. Episodes of tight dealer constraints – for instance, due to high leverage, Value-at-Risk, and funding costs – in turn go hand in hand with price inefficiencies due to law of one price deviations and elevated trading costs. We rationalise our novel empirical findings with a tractable model that sheds light on the key mechanisms of how market efficiency can deteriorate when dealers are more constrained.
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