OFR published a working paper on market-making costs and liquidity with respect to credit default swaps (CDS) market. The paper examines whether liquidity deteriorated in the single-name CDS market due to regulatory reforms after the 2007-09 financial crisis. It finds evidence of both increased spreads and lower volumes, consistent with the reforms increasing the cost of market-making for bank-dealers. It also finds that transaction prices between dealers and clients have become more dependent on the inventories of individual dealers as interdealer trade has declined.
The paper contributes to three separate strands of literature: on the market structure of bilateral markets and the behavior of dealers; the potential impact of the financial crisis reforms on market liquidity; and the empirical literature on inventory management and pricing by dealers, specifically for the single-name CDS markets. The paper provides background on the CDS markets and highlights the reforms that may have potentially influenced the behavior of CDS market participants—the Basel 2.5 and Basel III accords, rules requiring standardized financial contracts be cleared through central counterparties, the Volcker rule, the rules on margin requirements for bilateral transactions, and other rules, including the single counterparty credit limit rule.
In over-the-counter (OTC) markets, dealers facilitate trading by becoming market makers. The costs dealers face, including the cost of holding inventory on balance sheet, and the ease, or difficulty, of reducing their positions, determine the degree of liquidity they provide. A stylized model has been used to examine the implications of these costs on dealer behavior and market liquidity. The model is used to guide an empirical study of the single name CDS market between 2010-2016. It is found that transaction prices between dealers and clients have progressively become more dependent on the inventories of individual dealers rather than on the aggregate inventory across all dealers. It has also been found that the volume between clients and dealers decreases across all clients, with larger declines for clients that are depository institutions. Meanwhile, the volume of inter-dealer trades decreases, dealer inventories decline, and dealers with large inventories are more likely to trade with clients. These results are consistent with the view that regulatory reforms implemented following the 2007-09 financial crisis increased the cost of holding inventory for dealers and the cost of inter-dealer trading. While the results indicate that increased costs in the CDS markets have impacted liquidity provision, it cannot be ruled out that this was the intent of the reforms. To determine the socially optimal level of trading activity, it would be necessary to quantify both the benefits and costs of the level of trading. This remains an open question, both theoretically and empirically, for future research.
Keywords: Americas, US, Banking, Securities, Credit Default Swap, Liquidity, Market-Making Cost, Basel III, OTC Market, Regulatory Reform, OFR
Previous ArticleBCBS Updates Basel III Monitoring Workbook, Instructions, and FAQs
The Hong Kong Monetary Authority (HKMA) revised the Supervisory Policy Manual module CG-5 that sets out guidelines on a sound remuneration system for authorized institutions.
The European Banking Authority (EBA) published the final guidelines on the monitoring of the threshold and other procedural aspects on the establishment of intermediate parent undertakings in European Union (EU), as laid down in the Capital Requirements Directive (CRD).
In a recent Market Notice, the Bank of England (BoE) confirmed that green gilts will have equivalent eligibility to existing gilts in its market operations.
The Financial Conduct Authority (FCA) published the policy statement PS21/9 on implementation of the Investment Firms Prudential Regime.
The European Banking Authority (EBA) proposed regulatory technical standards that set out criteria for identifying shadow banking entities for the purpose of reporting large exposures.
The Board of the International Organization of Securities Commissions (IOSCO) proposed a set of recommendations on the environmental, social, and governance (ESG) ratings and data providers.
The European Securities and Markets Authority (ESMA) published recommendations from the Working Group on Euro Risk-Free Rates (RFR) on the switch to risk-free rates in the interdealer market.
The European Central Bank (ECB) published a paper as well as an article in the July Macroprudential Bulletin, both of which offer insights on the assessment of the impact of Basel III finalization package on the euro area.
The International Swaps and Derivatives Association (ISDA) published a paper that explores the impact of the Fundamental Review of the Trading Book (FRTB) on the trading of carbon certificates.
The Prudential Regulation Authority (PRA) published the remuneration policy self-assessment templates and tables on strengthening accountability.