Market Liquidity and Regulation

29 May 2018

A steady stream of research is finding that regulation is having real, measurable effects on market liquidity.  While there is evidence on both sides, research is pointing to diminished liquidity. The following papers are worth reviewing:

Paper: The Volcker Rule and Market-Making in Times of Stress:
Authors find that bond liquidity has declined since the Volcker Rule was enacted and that the decline in liquidity is concentrated among dealers that are subject to the Volcker rule.
Bao, Jack, Maureen O’Hara, and Alex Zhou (2016). “The Volcker Rule and Market-Making in Times of Stress,” Finance and Economics Discussion Series 2016-102. Washington: Board of Governors of the Federal Reserve System, https://doi.org/10.17016/FEDS.2016.102.

Paper: Customer Liquidity Provision: Implications for Corporate Bond Transaction Costs
Authors find that since 2008, substantial amounts of liquidity provision have moved from the dealer sector to the non-dealer sector and that the cost of executing trades in which customers demand liquidity has increased by between 35 and 50 percent.
Choi, Jaewon and Huh, Yesol, Customer Liquidity Provision: Implications for Corporate Bond Transaction Costs (October 20, 2017).
Available at SSRN: https://ssrn.com/abstract=2848344 or http://dx.doi.org/10.2139/ssrn.2848344

Paper: Inventory Management by Corporate Bond Dealers
Authors find that after the Volcker Rule was finalized, dealers were more reluctant to take bonds into inventory, were more likely to offset trades within a day and unwound inventory positions more quickly.
Schultz, Paul, Inventory Management by Corporate Bond Dealers (May 11, 2017).
Available at SSRN: https://ssrn.com/abstract=2966919 or http://dx.doi.org/10.2139/ssrn.2966919

Paper: Is Post-Crisis Bond Liquidity Lower? 
Authors find that after the financial crisis, bond liquidity is lower on days when market volatility increases significantly.
Anderson, Mike and Stulz, Rene M. Is Post-Crisis Bond Liquidity Lower? (April 2017).

Capital Commitment and Illiquidity in Corporate Bonds
Authors find that dealer capital commitment in the corporate bond market decreased during the financial crisis, continued to decline during the period in which the Volcker rule was enacted and that the decline in capital commitment is concentrated among bank-affiliated dealers subject to the Volcker Rule.
Bessembinder, Hendrik and Jacobsen, Stacey E. and Maxwell, William F. and Venkataraman, Kumar, Capital Commitment and Illiquidity in Corporate Bonds (August 28, 2017). Journal of Finance, Forthcoming.
Available at SSRN: https://ssrn.com/abstract=2752610 or http://dx.doi.org/10.2139/ssrn.2752610

The Cost of Immediacy for Corporate Bonds
Authors find that liquidity provision has become significantly more expensive since 2008 and also that dealers revert deviations from their target inventory more quickly which, the authors argue, is consistent with a stringent regulatory environment.
Dick-Nielsen, Jens and Rossi, Marco, The Cost Immediacy for Corporate Bonds (February 19, 2018).
Available at SSRN: https://ssrn.com/abstract=2139403 or http://dx.doi.org/10.2139/ssrn.2139403