Working Paper: NBER ID: w22332
Authors: Marco Di Maggio; Amir Kermani; Zhaogang Song
Abstract: This paper investigates the ways in which the network of relationships between dealers shapes their trading behavior in the corporate bond market. They charge lower spreads to dealers with whom they have the strongest ties, and this effect is all the more pronounced at times of market turmoil. Moreover, highly connected and systemically important dealers exploit their connections at the expense of peripheral dealers as well as clients, charging higher markups than to other core dealers, especially during periods of uncertainty. We show that following the collapse of a flagship dealer in 2008, trading chains lengthened by almost 20 percent and that the increase was even greater for the institutions that had the closest ties with the defaulted dealer. Finally, we find evidence that dealers drastically reduced their inventory during the financial crisis. These results can help inform the debate on the risks posed by the interconnectedness of the financial system, showing how this could be a source of market fragility and illiquidity.
Keywords: trading relationships; corporate bond market; market turmoil; dealer behavior; liquidity provision
JEL Codes: G01; G12; G14; G2
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| stronger prior relationships (L14) | lower markups (D43) |
| stronger prior relationships (L14) | lower spread charged (G19) |
| collapse of flagship dealer in 2008 (G33) | lengthened intermediation chains (F65) |
| financial crisis (G01) | reduced dealer inventories (L81) |
| inability to absorb excess supply (F35) | increased transaction costs (D23) |
| existing trading relationships (F10) | determine liquidity provision (E51) |
| existing trading relationships (F10) | influence pricing strategies (L11) |
| market turmoil (G10) | reliance on strongest ties (Z13) |