This paper aims to answer the question of whether post-crisis regulatory interventions caused a decline in liquidity. To serve this purpose, it investigates how individual provisions affect the market making business and how the corporate bond market changed in response to regulations. The paper approaches the issue by structuring theoretical and empirical evidence of corporate bond liquidity. It develops regulations impact levels from particular to aggregate, facilitating a perspicacious analysis. Important to note, the study attempts to assess neither welfare effects nor the desirability of regulations.
After the financial crisis, regulators intervened to enhance the resilience of the banking system. Their provisions range from capital and liquidity standards to the prohibition of single activities considered too risky. However, concerns arise that post-crisis regulations harm liquidity by imposing constraints on its providers. When liquidity is low, investors that want to trade large volumes must wait for counterparties or accept to trade below market prices. Therefore, in certain financial markets like that for corporate bonds, intermediaries emerged to facilitate market functioning. They enable investors to trade immediately, reconciling imbalances in supply and demand.
Illiquidity is costly for the economy as investors require compensation for holding riskier bonds. Amihud and Mendelson provide cross-sectional and time-series evidence of the resulting illiquidity discount. Hence, if regulations reduced liquidity, they would cause a depreciation of prices. Also, lower liquidity implies higher cost of debt and transaction costs, as well as a less efficient resource allocation. The regulatory impact on liquidity is, therefore, highly important for policymakers and investors.
Table of Contents
1. Introduction
2. Liquidity provision in equity and corporate bond markets
2.1. Equity markets
2.2. Corporate bond markets
3. Post-crisis regulatory provisions
3.1. Basel 2.5
3.2. Basel III
3.3. The Volcker Rule
4. First-order impact on dealer liquidity provision
4.1. The business model of market makers
4.2. Channels of regulatory impact
4.3. Foundations of contemporary literature
4.4. Evidence of the regulatory impact on traditional dealers
5. Changes in market structure and behavior
5.1. Second-order effect (1): Shift from principal trading to matchmaking
5.2. Second-order effect (2): Migration of market making to non-bank dealers
6. Evidence of aggregate corporate bond market liquidity
6.1. Price-based liquidity measures
6.2. Trading-based liquidity measures
6.3. Liquidity under stress
7. Conclusion
Research Objectives and Themes
The primary aim of this paper is to determine whether post-crisis regulatory interventions have led to a decline in liquidity within the corporate bond market. By analyzing how capital standards and trading restrictions affect the business models of market makers, the study explores the shifts in market structure and the behavioral responses of financial institutions to the new regulatory environment.
- Impact of Basel Accords and the Volcker Rule on dealer capital commitment.
- Transformation of market making business models from principal trading to matchmaking.
- Market entry of non-bank liquidity providers and their role in market stability.
- Evaluation of conventional liquidity measures and the emergence of market-wide "liquidity puzzles."
Excerpt from the Book
4.1. The business model of market makers
Market makers aim to generate facilitation revenues in the form of bid-ask spreads. For that, they must commit substantial capital, demonstrating the low-margin/high-volume nature of the business (CGFS, 2014). Besides, inventory revenues can result from appreciating positions. Market makers, however, typically evade these revenues as they reflect fundamental risk. Intuitively, to enter into principal trades, dealers expect revenues that outbalance costs. These are the cost of capital as well as financing and hedging costs.
By absorbing order imbalances into their balance sheets, dealers assume different risks for which they require compensation. For example, they bear the risk of trading with better-informed counterparties. Moreover, the usually unforeseeable emergence and direction of liquidity demand result in an uncertain exposure to market conditions. To manage these risks, dealers make decisions that pertain to the pricing, timing, and volume of trades (Duffie, 2012). A critical risk-sharing mechanism, as Schultz (2017) accentuates, is the interdealer market. Dealers, linked through intermediation chains, trade with each other to unwind their inventories and effectively provide liquidity.
Securities financing, like repurchase agreements (repos), enables market makers to encounter variable liquidity demand. Repos denote transactions in which dealers sell securities and agree to repurchase them subsequently. Thereby, dealers can simply pass on bondsto repo counterparties and use obtained funds to pay customers. That is, market makers must not have all assets on hand to provide liquidity. Repos represent a form of collateralized borrowing. Hence, from a dealers’ perspective, they lower financing costs and facilitate their risk management (Fontaine, Garriott & Gray, 2016).
Summary of Chapters
1. Introduction: Presents the motivation behind post-crisis regulations and the resulting concerns regarding corporate bond market liquidity, outlining the paper's central research goal.
2. Liquidity provision in equity and corporate bond markets: Contrasts the structure of equity markets with the quote-driven, fragmented nature of corporate bond markets.
3. Post-crisis regulatory provisions: Introduces the technical details of Basel 2.5, Basel III, and the Volcker Rule as the primary regulatory frameworks under investigation.
4. First-order impact on dealer liquidity provision: Analyzes the direct influence of regulations on bank-affiliated dealers' capital, inventory costs, and overall business models.
5. Changes in market structure and behavior: Examines second-order market changes, specifically the shift towards agency/matchmaking and the entry of non-bank market makers.
6. Evidence of aggregate corporate bond market liquidity: Reviews empirical findings regarding price-based and trading-based liquidity measures, addressing contradictions found in current literature.
7. Conclusion: Synthesizes the findings, noting that while conventional liquidity metrics may seem stable, structural changes have increased the cost of immediacy for market participants.
Keywords
Corporate Bond Market, Liquidity, Post-Crisis Regulation, Basel III, Volcker Rule, Market Making, Principal Trading, Matchmaking, Dealer Inventory, Bid-Ask Spread, Financial Regulation, Cost of Immediacy, Non-Bank Dealers, Systemic Risk, Market Structure.
Frequently Asked Questions
What is the core focus of this research paper?
The paper investigates the impact of post-crisis financial regulations, specifically Basel III and the Volcker Rule, on the liquidity of the U.S. corporate bond market and the behavior of market makers.
What are the central themes discussed in the work?
Key themes include the transformation of market maker business models, the constraints placed on dealer inventories, the rise of non-bank liquidity providers, and the debate surrounding the effectiveness of conventional liquidity measures.
What is the primary research question?
The central question is whether post-crisis regulatory interventions have led to a decline in corporate bond market liquidity and how the market has structurally adapted to these changes.
Which scientific methods are employed?
The paper performs a comprehensive literature review, synthesizing theoretical models and empirical evidence—often using TRACE data—to analyze the regulatory impact on market dynamics.
What is covered in the main section of the paper?
The main part details the mechanics of bank-affiliated dealer business models, explains how specific regulatory channels increase costs, and examines empirical evidence regarding how these factors change market structure and liquidity outcomes.
Which keywords best describe this study?
Central keywords include corporate bond liquidity, regulatory impact, market making, Basel III, and the Volcker Rule.
How does the Volcker Rule specifically affect bond trading?
It restricts proprietary trading by banks, which compels them to adopt "matchmaking" or "agency" trading models to avoid regulatory sanctions, thereby impacting the speed and availability of immediate trade execution.
What is the "transaction cost puzzle" mentioned in the text?
It refers to the observation that while some price-based liquidity measures (like bid-ask spreads) appear stable or have improved, the actual cost of immediate execution for investors has risen significantly.
- Citation du texte
- Michael Kreienbaum (Auteur), 2020, Regulation after the Financial Crisis. Impact on Corporate Bond Market Liquidity, Munich, GRIN Verlag, https://www.grin.com/document/1128191
