Corporate bond market evolution: Electronic trading cuts capital cost
A Philadelphia Fed working paper analyzes the evolution of the U.S. corporate bond market, focusing on dealer balance sheet costs, electronic trading, and mutual fund growth. It finds that electronic trading significantly reduced capital costs, though these gains were largely offset by other market changes.
Three forces reshape bond trading
The U.S. corporate bond market has undergone significant changes over the past two decades, driven by three major forces.
First, post-Global Financial Crisis regulations increased dealers' balance sheet costs, impacting their willingness to supply liquidity.
Second, a substantial share of trading volume migrated from traditional voice-based methods to electronic trading platforms, fostering competition among dealers.
Third, bond mutual funds and ETFs have increasingly replaced traditional institutional investors like life insurance companies and pension funds, leading to different trading needs.
This paper develops a theoretical model of a dealer-intermediated over-the-counter market to provide a unified analysis of these shifts.
The quantitative analysis suggests that while electronic trading significantly reduced the cost of raising capital, these gains were almost completely offset by the combined effects of rising balance sheet costs and evolving demand for liquidity.
Electronic trading also caused a meaningful decline in the bid-ask spread, whereas other structural changes had little effect on transaction costs.
Yields vs. spreads: A complex interplay
The model incorporates customer-dealer contact via both voice and electronic platforms, alongside the crucial role of dealer balance sheet space.
Calibrated to empirical data, it explores bid-ask spreads and liquidity yield spreads.
Rising dealer balance sheet costs lead to a sizable increase in the liquidity yield spread but little change in bid-ask spreads.
Similarly, increased customer trading needs raise the liquidity yield spread while bid-ask spreads remain largely unchanged.
Conversely, greater electronic trading prevalence significantly reduces both bid-ask and yield spreads.
The model links these outcomes through the condition determining dealers' optimal use of balance sheet space, connecting ask-side profits, liquidity yield spread, and bid-side profits.
Unpacking market dynamics
This theoretical analysis provides a valuable, unified framework for understanding the complex, often offsetting, forces at play in the corporate bond market.
By clarifying economic channels and quantifying their effects, the paper offers crucial insights into how market structure changes impact capital costs and transaction dynamics.
Its conceptual clarity and quantitative findings are highly relevant for policymakers assessing market evolution.