Although it is a highly desirable feature for securities markets in order to thrive, sufficient liquidity is barely recognized when being present. This study analyzes often neglected market liquidity in the corporate bond market after the introduction of comprehensive financial regulation in the USA, foremost associated with the Volcker Rule. Research identifies an increasing share of customer liquidity provision to be a reason for an underestimation of overall transaction costs, as spreads charged by customers are lower compared to market-makers’ spreads. With customers providing liquidity where market-makers do not, the overall spread averages decrease. The author applies this research results to collateralized loan obligations (CLOs) and the corporate bond market. This approach is new, since it directly tests the growth of liquidity provision by CLOs as non-Volcker affected vehicles replacing restricted market-makers.

Text sample: Chapter 3 Fundamentals of Corporate Bond Trading and Regulatory Influences: Due to a variety of individual features fixed income securities exhibit an inherently higher degree of complexity compared to stocks. This complexity transfers to their markets. Hence, it makes sense to portrait the characteristic features of the corporate bond market regarding its market infrastructure as well as its trading mechanics. Moreover, the impact of financial regulation on basic corporate bond market participants is elucidated. The end of chapter 3 illustrates the role of collateralized loan obligations in bond trading. 3.1 Infrastructure and Trading Mechanics of Corporate Bond Markets: Markets bring buyers and sellers together. Both are motivated to trade by either steering risk through hedging, taking advantage of beneficial information through speculation, or rebalancing their portfolio in case of liquidity shocks. In this subchapter, different security market infrastructures are illustrated and their respective trading mechanics are compared to one another. 3.1.1 Limit Order Book and OTC Markets: When trading securities, rules and mechanisms significantly differ depending on the form of market which in turn depends on the security traded. Auction or limited order markets represent the most automated market trading mechanics. By submitting orders, potential participants show their trading interest and a centralized, electronic trading platform automatically matches buy and sell trade requests. Conversely, in dealer markets or over-the-counter (OTC) markets, buyers and sellers find each other through an individual search, often facilitated by a market intermediary taking on this role. While stocks are typically traded on auction markets, corporate bonds are traded OTC. On the one hand, in a limit order market, all orders are submitted to one platform, the limited order book (LOB). The LOB is a centralized ledger which stores all incoming orders until they can be matched with an offsetting trade request. Within limit order markets, two different market types need to be distinguished in call markets, orders are executed at discrete intervals while in continuous markets trades are matched immediately – if possible. Otherwise they are also stored in the centralized LOB. Since LOB markets are highly automated, orders rely on algorithms for execution and trading decision. This reflects in the types of orders which can be submitted. Traders who value immediacy are likely to submit so called market orders that are instantly executed at the best market price available. In contrary, limit orders are only matched if a counterparty meets the asked price requirements set out by the trader who places the limit order. This might improve the execution price for the trader compared to the market price but reduces the likelihood for immediate order matching. On the other hand, in dealer markets potential participants need to actively search for a trading partner to match their orders. Often intermediaries in form of dealers, market-makers or brokers are involved to accumulate orders and eventually reduce the search costs for traders by matching buy and sell orders. Still, with lower price transparency traders might approach multiple dealers making prices dependent on bargaining power and each participant’s need for immediacy. While the former helps with reducing purchase prices (increasing sale prices), the latter aggravates price conditions, reflecting the issue of asymmetric information in OTC markets. With a higher level of an investor’s sophistication, tighter bid-ask spreads are reached. Bond markets are also often referred to as quote-driven. That is, clients request quotes from dealers when they intend to place an order. Therefore, customers are dependent on dealers since they cannot place orders anonymously. Hence, markets with a LOB are inherently faster, more transparent and after all more liquid due to the lower search and transaction costs involved. Abudy/Wohl provide empirical evidence for this theory through an application of a LOB for corporate bonds as it is the rare case at the Tel Aviv Stock Exchange. Early studies conducted by Viswanathan/Wang also show that risk-neutral customers would only prefer trading in a dealer market over a limit order market, if there is a vast number of market-makers and order sizes are large. However, corporate bonds are still mainly traded OTC. Several bond and bond market characteristics provide justification for this. Firstly, bonds are issued more often than e.g. stocks and with a lot more versatile features. That makes matching of buyers’ and sellers’ requests more difficult. Secondly, bonds are fixed income securities, i.e. bonds have a fixed payment structure and maturity date. Often, this makes trading in secondary markets not as necessary – especially as time moves closer to the maturity date. Thirdly, evidence of Biais/Green suggests that high volume trading investors of corporate bonds would potentially impact prices if a central LOB was introduced for bond trading. Obviously, this should not be the case. However, over the last decade electronification, referring to the shift from OTC to computer based trading, became a key challenge in the fixed income market. Even though electronic trading gradually replaces OTC trading, with regard to corporate bonds only small sized trades are concerned so far. Standardization and automatization caused by the electronification ease trading and reduces transaction cost. Still, if trading really moves to a central LOB in the near future remains questionable. In an effort to improve transparency of OTC fixed income markets, the Financial Industry Regulatory Authority (FINRA), responsible for overseeing brokerage firms interacting with the public in the USA, introduced the Trade Reporting and Compliance Engine (TRACE) in 2002. All brokers regulated by FINRA must report every executed trade within 15 minutes to TRACE where the data is stored and made available to the public. Securities eligible for TRACE are especially corporate bonds and agency debt, but also securitized products as e.g. ABS or MBS. Since prices are severely influenced by bargaining between broker and client compared to the stock market, TRACE helps with promoting a more transparent market by reducing the information asymmetries between buyer and seller of fixed income securities. Previous research shows that bonds subject to TRACE exhibit reduced transaction costs, making their markets more liquid. 3.1.2 Types of Dealers in OTC Markets: Three different types of intermediaries act as dealers in OTC markets: proprietary traders, market-makers and brokers. The latter operate exclusively as matchmakers between sellers and buyers on behalf of their clients. Transactions are only conducted when the broker finds customers to take on the counter position to the incoming orders at or near the same time”. Problems arise due to possible temporal discrepancies between incoming buy and sell orders. Hence, for the purpose of providing continuous trading, intermediaries need to hold inventory positions. Unlike brokers, market-makers may hold either long (act as counterpart to sell orders) or short (act as counterpart to buy orders) inventory positions in case there is no immediate match found for a trade. As a result, opportunity interest costs develop. These reflect the return which the invested capital could have produced, if used in an alternative investment opportunity. With ist price quotations, the market-maker then tries to return to ist original portfolio structure by making either sales or purchases more attractive. Since the height of the opportunity interest rate depends on the market-makers risk appetite (high risk appetite leads to high missed opportunity rates and vice versa), the quoted prices do, too. Furthermore, aside from this risk-oriented quote setting, the distribution of market-relevant information adds to the explanation of price building in market-maker markets. Both approaches are part of the competitive market-maker markets, which has been the predominant model since the 1980s. Many early researches find coherence between inventory holding and transaction costs, studying monopolistic market-maker markets. More recently, Adrian/Boyarchenko/Shachar provide evidence of institutional constraints on e.g. risk appetite, influencing the liquidity of the corporate bond market. Both, providing immediacy to market participants and absorbing temporary imbalances between supply and demand, make market-makers crucial for the liquidity of fixed income markets. Appendix 2 illustrates the market-maker’s interlinkages to ist in-house related departments and the market. Thereby the in-house constraints and external demands that need to be served are shown. Last, proprietary traders can also contribute to a market’s liquidity because they tend to trade often as well as large positions and hence, absorb market imbalances. In contrast to market-makers, proprietary traders are not involved in client business and therefore only trade with the purpose of making profit out of expected market price changes for their own accounts. Typical proprietary traders are large financial institutions or investment funds.

• OTC

• Financial Regulation

• Liquidity Provision

• Alternative Investment

• Market Liquidity

• Customer Liquidity Provision

Viktoria K. Klaus, M. Sc. was born in Princeton, NJ in 1995. During her Bachelor studies with focus on banking in Stuttgart, she developed her interests in financial markets. To deepen her statistical knowledge Klaus finished her master’s degree at the Catholic University Eichstätt-Ingolstadt in 2018. Following her research interests in financial regulation she started an audit trainee program focusing on capital market related topics at a German bank in 2019.