Working Paper

Dealer costs and customer choice

Abstract: We introduce a model to explain how an increase in intermediation costs leads to structural changes in the corporate bond market. We state three facts on corporate bond markets after the Dodd-Frank act: (1) an increase in customer liquidity provision through prearranged matches, (2) a paradoxical decrease in measured illiquidity, and (3) an increase in the illiquidity component on the yield spread. Investors take longer to finish a trade and require higher illiquidity premium even though measured illiquidity decreased. We introduce a search and matching model which explains these facts. It also suggests the possibility of multiple equilibria and financial instability when dealers face high costs to intermediate transactions.

Keywords: over-the-counter markets; intermediation costs; liquidity; corporate bonds; Volcker rule; post-2008 regulation;

JEL Classification: D53; G12; G18;

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Bibliographic Information

Provider: Federal Reserve Bank of Richmond

Part of Series: Working Paper

Publication Date: 2023-12

Number: 23-13