Customer Liquidity Provision: Implications for Corporate Bond Transaction Costs
49 Pages Posted: 8 Oct 2016 Last revised: 29 Jul 2018
Date Written: June 29, 2018
The convention in calculating trading costs in corporate bond markets is to estimate bid-ask spreads that non-dealers (customers) pay dealers, implicitly assuming that dealers always provide liquidity to customers. We show that, contrary to this assumption, customers increasingly provide liquidity particularly after the new banking regulations were adopted following the 2008 financial crisis and, thus, conventional bid-ask spread measures underestimate the cost of dealers' liquidity provision to customers. A substantial portion of liquidity provision has moved from the dealer sector to the non-dealer sector, consistent with decreased dealer risk capacity due to the stricter banking regulations. Among large trades wherein customers demand liquidity from dealers who use their inventory capacity, customers pay 40 to 80 percent higher spreads than before the crisis. Our results can help explain the puzzling finding in the literature that average bid-ask spread estimates 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
Suggested Citation: Suggested Citation