Peter Van Tassel, Federal Reserve Bank of New York
Or Shachar, Federal Reserve Bank of New York
Abstract: We show a significant loss in US Treasury market functionality when intensive use of dealer balance sheets is needed to intermediate bond markets, as in March 2020. Although yield volatility explains most of the variation in Treasury market liquidity over time, when dealer balance sheet utilization reaches sufficiently high levels, liquidity is much worse than predicted by yield volatility alone. This is consistent with the existence of occasionally binding constraints on the intermediation capacity of bond markets.
Discussant: Giang Nguyen, Pennsylvania State University
Abstract: Many financial markets are populated by dealers, who commit to regularly participate in the market, and non-dealers who do not commit. This market structure introduces a trade-off between competition and volatility, which we study using data on Canadian Treasury auctions. We document a consistent exit trend by dealers and increasing, but irregular participation by non-dealer hedge funds. Using a structural model, we evaluate the impact of dealer exit on hedge fund participation and its consequences on market competition and volatility. We find that hedge fund entry was partially driven by dealer exit, and that gains thanks to stronger competition associated with hedge fund entry are off-set by losses due to their irregular market participation. We propose an issuance policy that stabilizes hedge fund participation at a sufficiently high average level and achieves sizable revenue gains.
Discussant: Dmitry Livdan, University of California-Berkeley
Abstract: In over-the-counter markets, search frictions give rise to trading illiquidity while terms of trade are determined through strategic bargaining. This paper develops a highly tractable search-based theory that explicitly models strategic bargaining. In the model, investors’ bargaining powers are endogenized as functions of their types. The model predicts that the relationship between asset price and liquidity is non-monotonic in frictional markets with strategic bargaining. The price-liquidity relationship is positive for relatively liquid assets but negative for illiquid assets. The negative price-liquidity relationship is more prevalent during market stress, and the market average price-liquidity relationship may turn negative during severe crises.
Chotibhak Jotikasthira, Southern Methodist University
Christian Lundblad, University of North Carolina-Chapel Hill
Jinming Xue, Southern Methodist University
Abstract: Using machine learning techniques, we uncover an important number of dealers in the U.S. municipal bond market who focus on geographically adjacent states, a characteristic distinct from dealer centrality. These “specialized” dealers enjoy larger market shares in states with greater local ownership and in local bonds with more complex features. We also find that trades intermediated by these specialized dealers have significantly larger markups than those intermediated by national dealers. For the average retail trade, about two-thirds of the differential markup is attributed to rent, with the remaining third to the unique benefits of specialization. Only the latter matters for institution-sized trades. Together, these results suggest that specialized dealers possess some monopoly power yet also provide important differentiated services. Specialized dealers provide immediacy, reward customers with an allocation of new bond offerings, help customers overcome information frictions, and facilitate access to local investor clientele. The latter two account for the bulk of the specialization benefits. Over time, as transparency improves and local ownership declines, the average market share of specialized dealers decreases along with differential markups.
Discussant: Norman Schürhoff, University of Lausanne
