Non-Bank Dealing and Liquidity Bifurcation in Fixed-Income Markets

Abstract

Non-banks, such as principal trading firms and hedge funds, increasingly compete with bank-owned dealers in fixed income markets. Some market participants worry that if non-banks push out established bank dealers, liquidity will become unreliable during times of stress. We model non-bank entry and state-dependent liquidity provision where non-banks improve liquidity more during normal times than in stress. In our model, the entry of non-banks improves liquidity in large markets and provides opportunistic dealing in small, previously unserved markets. The downside is that banks may exit marginal asset markets under the threat of non-bank entry, reducing the reliability of liquidity provision.

Keywords: Fixed income, dealers, non-bank financial institutions, principal trading firms, hedge funds, liquidity, market structure, entry decisions

JEL Classification: G10, G20, G21, G23, L10, L13, L14