Finance and Economics Discussion Series (FEDS)
Customer Liquidity Provision: Implications for Corporate Bond Transaction Costs
Jaewon Choi and Yesol Huh
The convention in calculating trading costs in corporate bond markets is to assume that dealers provide liquidity to non-dealers (customers) and calculate average bid-ask spreads that customers pay dealers. We show that customers often provide liquidity in corporate bond markets, and thus, average bid-ask spreads underestimate trading costs that customers demanding liquidity pay. Compared with periods before the 2008 financial crisis, substantial amounts of liquidity provision have moved from the dealer sector to the non-dealer sector, consistent with decreased dealer risk capacity. Among trades where customers are demanding liquidity, we find that these trades pay 35 to 50 percent higher spreads than before the crisis. Our results indicate that liquidity decreased in corporate bond markets and can help explain why despite the decrease in dealers' risk capacity, average bid-ask spread estimates remain low.
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Keywords: Bank Regulation, Corporate Bond, Financial Intermediation, Liquidity, Volcker Rule
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