Customer Liquidity Provision: Implications for Corporate Bond Transaction Costs

Abstract

The convention in calculating corporate bond trading costs is to estimate bid-ask spreads that customers pay, implicitly assuming that dealers always provide liquidity to customers. We show that, contrary to this assumption, customers increasingly provide liquidity after the post-2008 banking regulations were adopted and, thus, conventional bid-ask spread measures underestimate the cost of dealers' liquidity provision to customers. Among large trades wherein dealers use inventory capacity, customers pay 35 to 60 percent wider spreads than before the crisis. Our results help explain the puzzling finding in the literature that transaction costs remain low despite the decrease in dealers' risk capacity.

Keywords: Corporate bond liquidity, Volcker Rule, Capital regulation, Bank regulations, Financial intermediation

JEL Classification: G10, G21, G28