Although there is a sizable literature demonstrating that liquidity and transaction costs are multidimensional, researchers continue to estimate adverse-selection costs using only prices. We present a model of a profit-maximizing specialist who posts prices and depths. The model is simulated to measure changes in the adverse-selection component of the spread that result under different levels of informed trading. We find that spread decompositions fail to capture the full extent of adverse-selection risk when specialists choose depth. We recommend that researchers use adverse-selection measures that account for depth as well as spread to mitigate this problem. 2006 The Southern Finance Association and the Southwestern Finance Association.

We use unique data from U.S. bank holding company-affiliated securities dealers to study the use of collateral in bilateral repurchase and securities lending agreements. Market participants' use of collateral differs substantially across asset classes: for U.S. Treasury securities transactions, we find that haircuts are large enough to provide full protection from default, whereas the same is not usually true for equities transactions. Further, although most of the equities in our sample are each associated with a unique haircut, most of the U.S. Treasury securities are each associated with more than one haircut. We relate these findings to implications of the zero value-at-risk feature that can be found in theories of collateral as an enforcement mechanism, and show that the data do not confirm these implications. We then turn to models of adverse selection that predict a negative relationship between haircuts and interest rates, based on the use of collateral as a screening mechanism. We find this negative relationship only for those trades in which the securities dealers are receiving U.S. Treasury securities and delivering cash.

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This note uses a unique dataset that matches banks' securities and loan portfolios to bank credit derivative transactions to characterize the basic features of how the largest banks in the U.S. use the single name CDS market in their investment portfolios.