Did Liquidity Providers Become Liquidity Seekers? Evidence from the CDS-Bond Basis during the 2008 Financial Crisis

49 Pages Posted: 24 Oct 2013 Last revised: 23 Dec 2014

See all articles by Jaewon Choi

Jaewon Choi

University of Illinois at Urbana-Champaign - Department of Finance

Or Shachar

Federal Reserve Bank of New York

Multiple version iconThere are 2 versions of this paper

Date Written: December 14, 2014

Abstract

The misalignment of corporate bond and credit default swap spreads (the CDS-bond basis) during the 2008 financial crisis is often attributed to corporate bond dealers' failure to provide liquidity. We investigate this common perception using unique data on dealers' trading. We show that corporate bond dealers provided liquidity in response to major selling activity by clients when the CDS-bond basis widened. Although providing liquidity, dealers did not trade aggressively enough to close the basis, consistent with the limited balance sheet capacity of dealer banks during the financial crisis. We also show that declines in bond prices following Lehman's collapse were concentrated in bonds with available CDS contracts and potentially high levels of activity in CDS-bond basis trades. Overall, our results suggest that liquidity demand due to the unwinding of basis trades by highly levered, non-dealer arbitrageurs was one of the main drivers of the large negative basis and the disruption of the credit market.

Keywords: CDS-bond basis, limits to arbitrage, Volcker rule, credit default swaps, liquidity, corporate bonds

JEL Classification: G12, G01

Suggested Citation

Choi, Jaewon and Shachar, Or, Did Liquidity Providers Become Liquidity Seekers? Evidence from the CDS-Bond Basis during the 2008 Financial Crisis (December 14, 2014). FRB of New York Staff Report No. 650, Available at SSRN: https://ssrn.com/abstract=2344342 or http://dx.doi.org/10.2139/ssrn.2344342

Jaewon Choi (Contact Author)

University of Illinois at Urbana-Champaign - Department of Finance ( email )

1206 South Sixth Street
Champaign, IL 61820
United States

Or Shachar

Federal Reserve Bank of New York ( email )

33 Liberty Street
New York, NY 10045
United States
(212) 720-6974 (Phone)
(212) 720-1582 (Fax)

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