Customer Liquidity Provision: Implications for Corporate Bond Transaction Costs

49 Pages Posted: 8 Oct 2016 Last revised: 29 Jul 2018

See all articles by Jaewon Choi

Jaewon Choi

University of Illinois at Urbana-Champaign - Department of Finance

Yesol Huh

Board of Governors of the Federal Reserve System - Division of Research and Statistics

Multiple version iconThere are 2 versions of this paper

Date Written: June 29, 2018

Abstract

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

Choi, Jaewon and Huh, Yesol, Customer Liquidity Provision: Implications for Corporate Bond Transaction Costs (June 29, 2018). Available at SSRN: https://ssrn.com/abstract=2848344 or http://dx.doi.org/10.2139/ssrn.2848344

Jaewon Choi

University of Illinois at Urbana-Champaign - Department of Finance ( email )

1206 South Sixth Street
Champaign, IL 61820
United States

Yesol Huh (Contact Author)

Board of Governors of the Federal Reserve System - Division of Research and Statistics ( email )

20th and C Streets, NW
Washington, DC 20551
United States
(202) 973-6943 (Phone)

HOME PAGE: http://sites.google.com/site/yesolhuh

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