Constrained Liquidity Provision in Currency Markets

We devise a simple model of liquidity demand and supply to study dealers’ liquidity provision in currency markets. Drawing on a globally representative data set of currency trading volumes, we show that at times when dealers' intermediation capacity is constrained the cost of liquidity provision increases disproportionately relative to dealer-intermediated volume. Consequently, the otherwise strong and positive relation between liquidity costs and trading volume diminishes significantly when dealers face tighter Value-at-Risk limits or higher funding costs. Using various econometric approaches, we show that this nonlinear effect of dealer constraints on market liquidity primarily stems from a reduction in the elasticity of liquidity supply, rather than changes in liquidity demand.