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
Date Written: December 14, 2014
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: Suggested Citation