The Value of Trading Relationships in Turbulent Times

Abstract

This paper investigates how the network of relationships between dealers shapes their trading behavior in the corporate bond market. We show that dealers tend to provide liquidity during periods of distress to the counterparties with whom they have the strongest tie. However, highly connected and systemically important dealers exploit their connections at the expense of peripheral dealers as well as of their clients, charging them higher markups than to other core dealers, especially during high-uncertainty periods. We then exploit the flagship collapse of a large dealer in 2008 as a shock to the network of relationships among dealers. We show that institutions with stronger ties to this dealer are forced to route their trades through longer intermediation chains to contact new counterparties, which charge them significantly higher prices. Moreover, we provide evidence suggesting that dealers did not lean against the wind; instead they drastically reduced their inventory during the financial crisis. These results inform the debate on the risks related to the interconnectedness of the financial system by showing how it might be a source of market fragility and illiquidity.

Keywords: OTC markets, network, corporate bonds, crisis, intermediation chains, leaning against the wind

JEL Classification: G12, G14, G24