How Post–Global Financial Crisis Regulations Impact Dealer Inventories and Liquidity in the OTC Market for U.S. Corporate Bonds

Over-the-counter (OTC) markets offer companies an opportunity to raise capital and investors the chance to earn a favorable return. Unlike exchanges, such as the New York Stock Exchange, which facilitate stock trades instantaneously, traditional OTC markets require dealer intermediation to complete trades. OTC trades often occur directly between dealers and customers and depend on both dealer willingness to hold inventory and customer demand for assets. (These types of trades between dealers and customers are called principal trades.)¹

In their paper, “Inventory, Market Making, and Liquidity in OTC Markets,” Assa Cohen of Yeshiva University; Mahyar Kargar of the University of Illinois Urbana–Champaign; Benjamin Lester of the Philadelphia Fed; and Pierre-Olivier Weill of UCLA, the National Bureau of Economic Research (NBER), and the Center for Economic Policy Research (CEPR) modeled a dealer-intermediated OTC market for U.S. corporate bonds, comparing outcomes before and after regulations were imposed in response to the Global Financial Crisis of 2007–2009.² “Maintaining liquid financial markets is crucial for a well-functioning economy,” they explain, motivating their research on post-Crisis regulations’ impact on OTC market dealer inventory costs, the amount of market liquidity, and welfare.

As background, the authors describe how dealers in OTC markets provide liquidity by holding inventory: Dealers take assets onto their balance sheets when customers are interested in selling their bonds quickly, and dealers use the assets to fulfill orders for other customers wanting to buy bonds without delay. Following the Global Financial Crisis, policymakers put in place new regulations to stabilize the financial system, including provisions that make it more expensive for OTC bond dealers to hold inventory.

To what extent do higher dealer inventory costs affect liquidity and welfare? To answer this pertinent question, the authors developed a structural model where dealers are the intermediaries for trades in the secondary OTC market for U.S. corporate bonds on behalf of their customers. Using transaction-level data on the U.S. corporate bond market,³ they conducted their analysis in two stages, first analyzing the pre–Global Financial Crisis period and then comparing it to the post-Crisis period. They measured the impact of regulatory changes on dealer inventory costs and optimal inventory choices, asset prices, transaction costs (and other measures of liquidity such as bid-ask spreads), and welfare.

To study the effects of rising inventory costs on dealers’ willingness to provide liquidity, the authors first faced a challenge: Standard models of OTC markets assume that dealers never actually hold inventory. Hence, a key innovation in their study is to explicitly incorporate inventories into a model of OTC trades by introducing a novel “inventory-in-advance constraint.” Specifically, the authors assume that dealers can buy any quantity of assets from customers but can only sell assets they currently hold in inventory. Meanwhile, dealers can access the interdealer market to adjust their portfolios.⁴ Accordingly, in the authors’ framework, dealers choose an optimal level of inventory (depending on their inventory costs) to meet the liquidity needs of their customers.⁵

The cost of holding inventory before the Global Financial Crisis, the authors found, was relatively small, and “hence dealers held sufficient inventory to fulfill most customer-buy orders in full.” However, by increasing inventory costs, regulations put in place post-Crisis led to a significant reduction in dealers’ inventory holdings, and, in turn, adversely affected levels of liquidity. (Flow of Funds data from the Federal Reserve show that the share of outstanding U.S. corporate bonds and nonagency mortgage-backed securities held by brokers and dealers fell from 2–3 percent in 2006 to less than 1 percent in 2018.)

The impact of post–Global Financial Crisis regulations on welfare, the authors determine, was even more dramatic. Following the imposition of the post-Crisis regulations, transaction costs associated with making trades, they found, increased modestly. However, these regulations had a more substantial impact on the welfare of investors. The welfare losses from the higher inventory costs after the regulations were imposed, they estimate, increased by between 1.75 and 2.4 percent, which is as much as double as compared with the preregulation period.⁶ They argue “a reduction in dealers’ inventory holdings can have significant consequences for misallocation.”

In summary, the authors were able to infer the implicit cost of post–Global Financial Crisis regulations on OTC dealers of U.S. corporate bonds, which, to the best of their knowledge, is new to the literature. By modeling the regulatory costs imposed by policymakers on the behavior of dealers and their customers, they show that the regulations played a central role in the long-run decline in dealer inventories, with negative implications for welfare. As an extension, they found the increase in dealer inventory costs can negatively affect corporate bond prices and, hence, raise firms’ cost of capital.