Customer Liquidity Provision: Implications for Corporate Bond Transaction Costs

Abstract

The convention when 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 following the adoption of post-2008 banking regulations and, thus, conventional bid-ask spread measures underestimate the cost of dealers' liquidity provision. Among large trades wherein dealers use inventory capacity, customers pay 40 to 60 percent wider spreads than before the crisis. Customers' balance-sheet capacity and their trading relationships with dealers are important determinants of customer liquidity provision.

Keywords: Corporate bond liquidity, Customer Liquidity Provision, Bank regulations and OTC liquidity, Insurer Liquidity Provision

JEL Classification: G10, G21, G28