Working Paper: NBER ID: w30775
Authors: Giulia Brancaccio; Karam Kang
Abstract: This paper shows that product design shapes search frictions and that intermediaries leverage this channel to increase their rents in the context of the U.S. municipal bond market. The majority of bonds are designed via negotiations between a local government and its underwriter. They are then traded in a decentralized market, where the underwriter often also acts as an intermediary. Exploiting variations in state regulations that limit government officials’ conflicts of interest, we provide evidence that bond design from the government’s perspective involves a trade-off between flexibility and liquidity, but the underwriter benefits from designing and trading complex bonds. Motivated by these findings, we build and estimate a model of bond origination and trades to quantify market inefficiency driven by underwriters’ role in intermediating trades and discuss policy implications.
Keywords: complexity; decentralized market; intermediaries; negotiation; product design; revolving-door regulation; search frictions; vertical relations
JEL Codes: L0; L12; L15; P0
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| prevalence of nonstandard provisions in bonds (H74) | underwriters' profit (G22) |
| design of bonds (G12) | trading frictions for investors (F12) |
| trading frictions for investors (F12) | higher government costs (H59) |
| nonstandard provisions (Y20) | default risk for governments (H74) |
| nonstandard provisions (Y20) | trading frictions for investors (F12) |
| underwriters' influence over bond design (G32) | market efficiency (G14) |
| Revolving door regulations (K23) | prevalence of nonstandard provisions in bonds (H74) |