Middlemen Matter: Corporate Bond Market Liquidity and Dealer Inventory Funding

59 Pages Posted: 10 Nov 2016 Last revised: 31 Jan 2019

See all articles by Andreas C. Rapp

Andreas C. Rapp

Federal Reserve Board of Governors

Date Written: September 2018


Corporate bond dealers build up considerable inventories for which they rely on short-term funding. I provide empirical evidence that dealers' inventory financing constraints are a crucial determinant of the costs of their liquidity provision in corporate bond markets. Constructing a unique dataset that links dealer identities with transaction prices, I show that dealer-specific financing constraints (as proxied by their CDS spreads) explain a substantial part of the variation in the inventory cost component of the effective bid-ask spread. Compared to low volatility bonds, the liquidity provision of high volatility bonds is more sensitive to inventory costs, especially during periods of funding stress. Finally, exploiting a quasi-natural experiment, I show that the relaxation of funding constraints through a Federal Reserve emergency credit facility temporarily alleviates liquidity problems among eligible dealers.

Keywords: Dealer Behavior, Effective Bid-Ask Spread, Inventory Cost, Liquidity, Corporate Bonds, Financial Crisis

JEL Classification: G01, G12, G18, G22, G24

Suggested Citation

Rapp, Andreas C., Middlemen Matter: Corporate Bond Market Liquidity and Dealer Inventory Funding (September 2018). Available at SSRN: https://ssrn.com/abstract=2867531 or http://dx.doi.org/10.2139/ssrn.2867531

Andreas C. Rapp (Contact Author)

Federal Reserve Board of Governors ( email )

20th Street and Constitution Avenue NW
Washington, DC 20551
United States

HOME PAGE: http://https://www.federalreserve.gov/econres/andreas-c-rapp.htm

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