How Has Post-Crisis Banking Regulation Affected Hedge Funds and Prime Brokers?
“Arbitrageurs” such as hedge funds play a key role in the efficiency of financial markets. They compare closely related assets, then buy the relatively cheap one and sell the relatively expensive one, thereby driving the prices of the assets closer together. For executing trades and other services, hedge funds rely on prime brokers and broker-dealers. In a previous Liberty Street Economics blog post, we argued that post-crisis changes to regulation and market structure have increased the costs of arbitrage activity, potentially contributing to the persistent deviations in the prices of ...
Alternative Trading Systems in the Corporate Bond Market
We investigate the trading of corporate bonds on alternative trading system (ATS) platforms. We draw a key distinction between request-for-quote (RFQ) and electronic communication network (ECN) trading protocols, which balance investors’ preference for immediacy and anonymity. Trades on ATS platforms are smaller and more likely to involve investment-grade bonds. Trades on ATS platforms are more probable for older, less actively traded bonds from smaller issues and for bonds traded by more dealers where inventory is high. Moreover, dealer participation on ATS platforms is associated with ...
The Long and Short of It: The Post-Crisis Corporate CDS Market
The authors establish key stylized facts about the post-crisis evolution of trading and pricing of credit default swaps. Using supervisory contract-level data, they show that dealers became net buyers of credit protection starting in the second half of 2014, both through reducing the amount of protection they sell in the single-name market and switching to buying protection in the index market. More generally, they argue that considering simultaneous positions in different types of credit derivatives is crucial for understanding institutions’ decisions to participate in these markets and ...
The Evolving Market for U.S. Sovereign Credit Risk
How should we measure market expectations of the U.S. government failing to meet its debt obligations and thereby defaulting? A natural candidate would be to use the spreads on U.S. sovereign single-name credit default swaps (CDS): since a CDS provides insurance to the buyer for the possibility of default, an increase in the CDS spread would indicate an increase in the market-perceived probability of a credit event occurring. In this post, we argue that aggregate measures of activity in U.S. sovereign CDS mask a decrease in risk-forming transactions after 2014. That is, quoted CDS spreads in ...
What’s in A(AA) Credit Rating?
Rising nonfinancial corporate business leverage, especially for riskier “high-yield” firms, has recently received increased public and supervisory scrutiny. For example, the Federal Reserve’s May 2019 Financial Stability Report notes that “growth in business debt has outpaced GDP for the past 10 years, with the most rapid growth in debt over recent years concentrated among the riskiest firms.” At the upper end of the credit spectrum, “investment-grade” firms have also increased their borrowing, while the number of higher-rated firms has decreased. In fact, there are currently ...
Changes in the Returns to Market Making
Since the financial crisis, major U.S. banking institutions have increased their capital ratios in response to tighter capital requirements. Some market analysts have asserted that the higher capital and liquidity requirements are driving up the costs of market making and reducing market liquidity. If regulations were, in fact, increasing the cost of market making, one would expect to see a rise in the expected returns to that activity. In this post, we estimate market-making returns in equity and corporate bond markets to assess the impact of regulations.
Redemption Risk of Bond Mutual Funds and Dealer Positioning
Market participants have recently voiced concerns that bond markets seem to become illiquid precisely when they want to sell bonds. Some possible reasons for a decline in corporate bond market liquidity in times of stress include the increasing share of corporate bond ownership by mutual funds and the reduced share of corporate bond ownership by dealers. In this post, we examine the potential effects of outflows from bond mutual funds and the role of dealers? positioning in corporate bonds.
Market liquidity after the financial crisis
This paper examines market liquidity in the post-crisis era in light of concerns that regulatory changes might have reduced dealers? ability and willingness to make markets. We begin with a discussion of the broader trading environment, including an overview of regulations and their potential effects on dealer balance sheets and market making, but also considering additional drivers of market liquidity. We document a stagnation of dealer balance sheets after the financial crisis of 2007-09, which occurred concurrently with dealer balance sheet deleveraging. However, using high-frequency trade ...
Dealer balance sheets and bond liquidity provision
Do regulations decrease dealer ability to intermediate trades? Using a unique data set of dealer-bond-level transactions, we link changes in liquidity of individual U.S. corporate bonds to dealers? transaction activity and balance sheet constraints. We show that, prior to the financial crisis, bonds traded by more levered institutions and institutions with investment-bank-like characteristics were more liquid but this relationship reverses after the financial crisis. In addition, institutions that face more regulations after the crisis both reduce their overall volume of trade and have less ...
We study how the risks to future liquidity flow across corporate bond, Treasury, and stock markets. We document distribution ?flight-to-safety? effects: a deterioration in the liquidity of high-yield corporate bonds forecasts an increase in the average liquidity of Treasury securities and a decrease in uncertainty about the liquidity of investment-grade corporate bonds. While the liquidity of Treasury securities both affects and is affected by the liquidity in the other two markets, corporate bond and equity market liquidity appear to be largely divorced from each other. Finally, we show that ...