Download This PaperCross-Market Liquidity and Dealer Profitability: Evidence from the Bond and CDS Markets
57 Pages Posted: 23 Jul 2018 Last revised: 6 Apr 2020
Date Written: June 29, 2018
Abstract
We study how the credit desk profitability of U.S. dealers that trade corporate bonds and single-name credit default swaps (CDS) affects the level and correlation of liquidity in these two markets. Supervisory datasets allow us to identify the dealers involved in each transaction and to observe their daily profit and loss (P&L). We find that profitability is important for bond liquidity and for liquidity correlation. Through the lens of a stylized model, we highlight that the impact of P&L on liquidity correlation depends on the interaction between profitability and inventory pressure driven by liquidity demand correlation. The interaction is richer when market stress is low, which has implications for measuring the impact of P&L on liquidity correlation, especially for complex intermediaries. For these institutions, inventory pressure arguably also reflects variables that are difficult to measure, like risk offsetting across business lines, but that are crucial to understanding the dynamics of liquidity comovement.
Keywords: bonds; credit default swaps; liquidity provision; dealer profitability
JEL Classification: G21; G23; G24
Suggested Citation: Suggested Citation
Pawel Szerszen (Contact Author)
Board of Governors of the Federal Reserve System ( email )
20th Street and Constitution Avenue NW
Washington, DC 20551
United States
HOME PAGE: http://www.federalreserve.gov/research/staff/szerszenpawelj.htm