The liquidity mechanics of dealer banks in the market-based credit system

Abstract

Are US government bonds (Treasuries) as good as cash? Conventional wisdom in academia and industry says that their safety and liquidity make Treasuries a cash-substitute. This paper shows that Treasuries stop being as good as cash when dealer banks face excessive liquidity risk. Using data from US money markets from July 2001–Feb 2018, I use regression analyses to examine how the liquidity risk in Treasuries and in money and bond markets more generally depends on the health of market-makers, specifically, dealer banks. I find that market-making exposes dealer banks themselves to liquidity risk, which depends on the quality of collateral in dealers' short-term credit operations. Dealer banks’ own liquidity risk is an important driver of liquidity risk in Treasuries and more broadly in money and bond markets. As a rationale for the results, I develop a mechanism how dealers manufacture liquidity in the market-based credit system.