Risk-averse dealers in a risk-free market—The role of trading desk risk limits

Abstract

We show that self-imposed risk limits significantly constrain dealers’ risk-taking and Treasury market intermediation, especially during market stress. Dealers near value-at-risk (VaR) limits reduce positions and demand higher compensation for risk. During March 2020, constrained dealers sold more Treasuries to the Fed at lower prices and provided less liquidity to clients. An aggregate measure of dealer VaR constraints closely tracks Treasury market illiquidity. Our findings offer a micro-foundation for the volatility–liquidity link and show that, in crises, policy actions that remove risk from intermediary balance sheets may be more effective at supporting Treasury market functioning than regulatory relief.