Providing Liquidity in an Illiquid Market: Dealer Behavior in U.S. Corporate Bonds
66 Pages Posted: 1 Jun 2017 Last revised: 21 Jul 2018
Date Written: May 18, 2018
We examine market making behavior of dealers for 55,988 corporate bonds, many of which trade infrequently. Dealers have a substantially higher propensity to offset trades within the same day rather than committing capital for longer periods for riskier and less actively traded bonds. Dealers’ holding periods do not decline with a bond’s prior trading activity, and in fact are lowest for some of the least active bonds. As a result, cross sectional estimates of roundtrip trading costs do not increase as prior trading activity declines. Our results suggest that dealers endogenously adjust their behavior to mitigate inventory risk from trading in illiquid and higher risk securities, balancing search and inventory costs in equilibrium such that observed spreads can appear invariant to expected liquidity.
Keywords: Corporate Bond Illiquidity, Capital Commitment, Dealer Inventory, Market-Making, transparency, TRACE, transaction costs
JEL Classification: G14, G23, G24, G28
Suggested Citation: Suggested Citation