Over-the-counter frictions systematically drive yield spread changes

Nils Friewald, Florian Nagler 30 January 2019

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Liquidity and the efficient allocation of assets among investors are important policy concerns in over-the-counter markets. Generally, three main frictions characterise the intermediation in over-the-counter  markets. 

  • First, dealers commit capital to inventory management. Hence, they act as intermediate buyers and sellers of assets by providing liquidity to customers through inventories. 
  • Second, investors have to search for counterparties because there is no centralised trading platform that eases the matching between sellers and buyers. 
  • Third, when two counterparties meet, they need to bargain over the terms of the trade. 

US corporate bonds trade in an over-the-counter market and it is unclear to what extent inventory, search, and bargaining frictions affect prices. Previous empirical studies, such as Collin-Dufresne et al. (2001), show that it is difficult to explain yield spread changes by conventional factors. Specifically, they show that a large set of firm-specific and macroeconomic factors can only poorly explain yield spread changes. Moreover, they find that most of the unexplained variation comes from a single factor that is not firm specific.

In our study (Friewald and Nagler 2018), we investigate whether systematic over-the-counter frictions drive the latent common component of yield spread changes. We use detailed transaction data of the Trade Reporting and Compliance Engine, which is maintained by the Financial Industry Regulatory Authority. The dataset contains anonymised information on dealer identities. We exploit the granularity of the data to construct twelve systematic proxies for the intensity of inventory, search, and bargaining frictions in the US corporate bond market from the beginning of 2003 to the end of 2013. 

Constructing proxies for systematic inventory, search, and bargaining frictions

We measure the intensity of inventory frictions by the aggregate order flow. We also examine other variables that assess the risk aversion and the funding costs of dealers. For example, we use dealers’ propensity to prearrange trades (more prearranged trades indicate higher aversion to holding inventory) and the TED spread, respectively.1 To provide estimates of the intensity of search frictions we trace bonds through the inter-dealer network and exploit the properties of the intermediation flows. For example, we estimate the centrality of the inter-dealer network and hypothesise that a closer connected inter-dealer market is indicative of lower search frictions. We also compute intermediation chains and exploit their properties. For example, we use the length of intermediation chains and conjecture that longer chains suggest a larger intermediary sector and allocations that are more competitive. Figure 1 shows the time series of the centrality of the inter-dealer market as well as of the chain length. The dealer centrality measures peaks at the onset of the financial crisis, while the length of chains steadily increases over time. 

Figure 1 Centrality of the inter-dealer market (top panel) and length of intermediation chains (bottom panel)

Further, to assess the bargaining power of dealers relative to customers we exploit, for example, the idea that the bargaining power of customers increases when they have more outside options to trade. Further, we conjecture that dealers’ bargaining power diminishes when the dealer market becomes more competitive and, thus, less concentrated. The top panel in Figure 2 shows the average number of outside options of customers, while the right panel shows a concentration measure of the dealer market based on the transacted volumes of dealers with customers. The patterns indicate a clear shift in bargaining power from dealers to customers over time.

Figure 2 Customers’ outside options (top panel) and concentration of inter-dealer market (bottom panel)

We then use our proxies of systematic over-the-counter frictions to explain the common factor of yield spread changes. We find that over-the-counter frictions explain around 23% in the variation of the common component. Further, we show that as much as one third of the total explained variation in yield spread changes is due to over-the-counter frictions. As expected, yield spreads increase the more reluctant dealers are in using their inventory to provide liquidity to customers. Further, when search frictions intensify yield spreads widen too. Similarly, as the bargaining power of dealers increases – implying that they can extract higher intermediation rents – the yield spreads rise as well. 

We provide an array of additional tests to exclude other potential drivers of our results. For example, our results remain robust after controlling for time-varying risk premiums or asymmetric information frictions. We also show that the general insights of our findings are unaffected by the period of the Global crisis, and that systematic over-the-counter frictions affect yield spread changes also outside of that period. Overall, our findings show that a considerable fraction of the time-variation of yield spread changes is due to over-the-counter market frictions.

The combination of search and bargaining frictions matters more than inventory frictions

Which type of friction matters the most for explaining yield spread changes? We find that a combination of search and bargaining frictions explains around 18% of the common variation of yield spread changes, while inventory frictions explain around 14%. Thus, the combination of search and bargaining frictions is slightly more important for the dynamics of yield spread changes than inventory frictions. The economic pricing impact of inventory frictions is around five basis points, while those of search and bargaining are around four basis points each. Our obtained economic pricing impacts are considerable, given that the standard deviation of monthly yield spread changes is close to 31 basis points. 

In summary, we show that systematic over-the-counter market frictions are a major driver of yield spread changes. Our findings are broadly consistent with leading theories of intermediation frictions in over-the-counter markets.

References

Collin-Dufresne, P, R S Goldstein and S J Martin (2001), “The determinants of credit spread changes”, Journal of Finance 56: 2177-2207.

Friewald, N and F Nagler (2018), “Over-the-counter market frictions and yield spread changes”, Journal of Finance, forthcoming (also CEPR Discussion Paper 13345).

Endnotes

[1] The TED spread is the difference between the interest rates on interbank loans and on short-term US government debt (‘T-bills’).

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Topics:  Financial markets International finance

Tags:  over-the-counter frictions, yield spreads, trading, US, financial markets

Professor of Finance, Norwegian School of Economics (NHH)

Assistant Professor of Finance, Bocconi University

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