Post-Crisis Regulations, Trading Delays, and Increasing Corporate Bond Liquidity Premium

91 Pages Posted: 2 Jun 2020 Last revised: 12 Aug 2022

See all articles by Botao Wu

Botao Wu

The Chinese University of Hong Kong (CUHK) - CUHK Business School

Date Written: April 1, 2020

Abstract

I examine corporate bond market liquidity from 2004 to 2019 through the lens of the liquidity premium. I document that while commonly-used transaction cost measures such as the bid-ask spread have been declining, the corporate bond liquidity premium has actually increased since the financial crisis. For speculative bonds, about 30% of their yield spread now compensates for illiquidity compared to 15% before the crisis. I argue that post-crisis regulations have increased dealer's market making costs, forcing dealers to reduce their market making. This has caused investors to experience much longer trading delays, and so require a higher liquidity premium than before the crisis. Using a structural over-the-counter model, I estimate the unobserved trading delays that are implied by the size of the liquidity premium, and show that bonds that took less than one day to sell before the financial crisis now take weeks to trade. Finally, I establish a causal relationship between the major post-crisis regulations and the variations in the corporate bond liquidity premium and trading delays. I show that Basel II.5, by introducing more stringent capital requirements for credit products, contributed the most to increasing the liquidity premium and trading delays out of the regulatory changes examined.

Keywords: Corporate Bond, Liquidity Premium, Trading Delays, Basel II.5

JEL Classification: G10, G12, G18, G20

Suggested Citation

Wu, Botao, Post-Crisis Regulations, Trading Delays, and Increasing Corporate Bond Liquidity Premium (April 1, 2020). NYU Stern School of Business, Available at SSRN: https://ssrn.com/abstract=3613379 or http://dx.doi.org/10.2139/ssrn.3613379

Botao Wu (Contact Author)

The Chinese University of Hong Kong (CUHK) - CUHK Business School ( email )

Cheng Yu Tung Building
12 Chak Cheung Street
Shatin, N.T.
Hong Kong

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