[We provide a model that links an asset's market liquidity (i.e., the ease with which it is traded) and traders' funding liquidity (i.e., the ease with which they can obtain funding). Traders provide market liquidity, and their ability to do so depends on their availability of funding. Conversely, traders' funding, i.e., their capital and margin requirements, depends on the assets' market liquidity. We show that, under certain conditions, margins are destabilizing and market liquidity and funding liquidity are mutually reinforcing, leading to liquidity spirals. The model explains the empirically documented features that market liquidity (i) can suddenly dry up, (ii) has commonality across securities, (iii) is related to volatility, (iv) is subject to "flight to quality," and (v) co-moves with the market. The model provides new testable predictions, including that speculators' capital is a driver of market liquidity and risk premiums.]

We provide a model that links an asset's market liquidity (i.e., the ease with which it is traded) and traders' funding liquidity (i.e., the ease with which they can obtain funding). Traders provide market liquidity, and their ability to do so depends on their availability of funding. Conversely, traders' funding, i.e., their capital and margin requirements, depends on the assets' market liquidity. We show that, under certain conditions, margins are destabilizing and market liquidity and funding liquidity are mutually reinforcing, leading to liquidity spirals. The model explains the empirically documented features that market liquidity (i) can suddenly dry up, (ii) has commonality across securities, (iii) is related to volatility, (iv) is subject to “flight to quality,” and (v) co-moves with the market. The model provides new testable predictions, including that speculators' capital is a driver of market liquidity and risk premiums.

We study a simple model of liquidity risk management in which a firm is subject to rollover risk. When a firm is unable to rollover its maturing bonds by issuing new bonds, it may have to seek more expensive sources of financing or even liquidate its assets, possibly at fire-sale prices. One way to reduce this risk is to hold excess cash reserves, which can be expensive in practice (Bengt Holmström and Jean Tirole 2000; 2001). In this paper, we focus on an alternative way of managing liquidity risk, through the optimal (dynamic) choice of the maturity structure of debt. Our analysis highlights one advantage of short-term financing. The firm, while in good financial health, can readjust its maturity structure more quickly in response to changes in its asset value. Ideally, the firm would secure long-term financing just prior to when its financial health may worsen. Through this strategy, the firm can secure financing for the longest continuous period possible without rollover failure, avoiding inefficient restructuring costs. Put differently, the objective of the firm with long-term assets is to maximize the effective maturity of its liabilities across several refinancing cycles, rather than to maximize the maturity of the current bonds outstanding.