Market-Making Costs and Liquidity: Evidence from CDS Markets

47 Pages Posted: 13 Mar 2019 Last revised: 23 Oct 2019

See all articles by Mark E. Paddrik

Mark E. Paddrik

Government of the United States of America - Office of Financial Research

Stathis Tompaidis

University of Texas at Austin - McCombs School of Business

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Date Written: March 12, 2019

Abstract

In over-the-counter markets, dealers facilitate trading by becoming market makers. The costs dealers face, including the cost of holding inventory on balance sheet, and the ease, or difficulty, of reducing their positions, determine the degree of liquidity they provide. We provide a stylized model to examine the implications of these costs on dealer behavior and market liquidity. We use the model to guide an empirical study of the single-name credit default swap (CDS) market between 2010-2016. We find that transaction prices between dealers and clients have progressively become more dependent on the inventories of individual dealers rather than on the aggregate inventory across all dealers. We also find that the volume between clients and dealers decreases across all clients, with larger declines for clients that are depository institutions. At the same time, the volume of interdealer trades decreases, dealer inventories decline, and dealers with large inventories are more likely to trade with clients. Our results are consistent with the view that regulatory reforms implemented following the 2007-09 financial crisis increased the cost of holding inventory for dealers, and the cost of interdealer trading.

Suggested Citation

Paddrik, Mark Endel and Tompaidis, Stathis, Market-Making Costs and Liquidity: Evidence from CDS Markets (March 12, 2019). OFR 19-01, Available at SSRN: https://ssrn.com/abstract=3351288 or http://dx.doi.org/10.2139/ssrn.3351288

Mark Endel Paddrik (Contact Author)

Government of the United States of America - Office of Financial Research ( email )

717 14th Street, NW
Washington DC, DC 20005
United States

Stathis Tompaidis

University of Texas at Austin - McCombs School of Business ( email )

Austin, TX 78712
United States

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