Market Liquidity After the Financial Crisis

Abstract

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 and quote data for U.S. Treasury securities and corporate bonds, we find only limited evidence of a deterioration in market liquidity.

Banking Regulation and Market Making

“…It is smaller in the long and short regions and weakly smaller in the agency region (as the dealer already took a zero position in the baseline case). The prediction that regulation pushes dealers to hold smaller positions is consonant with results in the empirical literature(Bessembinder et al 2018;Bao et al 2018;Schultz 2017;Adrian et al 2017). While the model yields a monotonic prediction for dealer inventory, it does not for the trading volume.…”

“…The ambiguous result calls into question the usefulness of measuring trading volume and of using other volume metrics (such as days of zero trades) to assess the costs of regulation, which forms part of the analysis in Trebbi and Xiao (2017) or Adrian et al (2017). This result is consonant with findings that dealers are moving toward a relatively greater agency basis of trade (Bessembinder et al 2018;Choi and Huh 2018).…”

“…2 Bao et al (2018); Dick-Nielsen and Rossi (2018); Schultz (2017). 3 Trebbi and Xiao (2017); Adrian et al (2017); Anderson and Stulz (2017);Mizrach (2015). 4 However, Bao et al (2018) find specific events cause mildly wider bid-ask spreads, which the model can match if there is a withdrawal of a dealer from the market after the event.…”

Customer Liquidity Provision: Implications for Corporate Bond Transaction Costs

“…Next, we also show that this underestimation problem is severe for commonly used measures of bid-ask spreads in the literature, namely, the implied roundtrip costs of Feldhütter (2012) and the bid-ask spread estimates based on differences in customer buy and sell prices used in Hong and Warga (2000) and Adrian, Fleming, Shachar and Vogt (2017). These measures implicitly treat DC-DC trades as customer trades seeking immediacy and also put higher weights on those trades.…”

“…First, dealers-especially those more heavily affected by various bank regulations-have decreased capital commitment and liquidity provision (Bessembinder, Jacobsen, Maxwell and Venkataraman (2017), Bao, O'Hara and Zhou (2017), and Schultz (2017)). However, broad price-based measures of liquidity have not worsened (Trebbi and Xiao (2017), Adrian, Fleming, Shachar and Vogt (2017), Anderson and Stulz (2017)). Finally, liquidity during specific market stress or liquidity events, such as rating downgrades or index rebalancing, has worsened (Bao et al (2017), Dick-Nielsen and Rossi (2016)).…”