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FIIE-10: Liquidity Provision and Collateral
Window-Dressing and Trading Relationships in the Tri-Party Repo Markets
Federal Reserve Board
We analyze window-dressing in the wake of the Basel III regulatory framework that emerged from the aftermath of the global financial crisis. We estimate that European dealers reduced their tri-party repo borrowing by 18% points to look more attractive to their regulators on financial reporting days in response to Basel III. Using a proprietary data set in a difference-in-differences setting, we exploit the region-specific implementation of Basel III, and the inception of the Federal Reserve's reverse repo facility (RRP) to examine the effects of window-dressing on trading relationships. We find that those money funds that cannot trade with the Fed lent 20% less to European dealers that withdrew from the repo market on financial reporting days. This result suggests that without the Fed's RRP facility, window-dressing would likely have increased funding costs for European dealers.
The Role of the Government Bond Lending Market in Collateral Transformation
1Georgetown University; 2European Central Bank
The securities lending market for government bonds is an active short-term funding market which not only facilitates repo and cash markets, but also plays a unique role in transforming collateral from low-quality into high-quality liquid assets. We provide strong evidence of an increase in scarcity of safe assets and document the role of the securities lending market in collateral upgrading. During periods of market stress, lending fee increases significantly more for higher quality bonds, consistent with a flight-to-quality effect. In addition, borrowers increase the use of low-quality noncash collateral to upgrade to high-quality securities. Furthermore, there is increased usage of such borrowed securities to obtain cash in the repo market. This evidence is consistent with collateral upgrading in the lending market to obtain cash in the repo market. Finally, we show that central bank purchases of low-quality bonds mitigated disruptions in short-term funding markets by reducing fees of these lower quality bonds.
Customer Liquidity Provision: Implications for Corporate Bond Transaction Costs
1University of Illinois at Urbana-Champaign; 2Federal Reserve Board
Convention in calculating trading costs in corporate bond markets is to assume that dealers provide liquidity to non-dealers (customers), and calculate the average bid-ask spreads that customers pay dealers. We show that customers often provide liquidity in the corporate bond markets, and thus, the average bid-ask spreads underestimate the trading costs that customers demanding liquidity pay. Compared to the pre-crisis or pre-regulation periods, substantial amount of liquidity provision has moved from the dealer sector to the non-dealer sector, consistent with decreased dealer risk capacity due to new bank regulations or shifts in banks' risk preferences. If we isolate trades where customers are demanding liquidity, we find that these trades pay 35-50% higher spreads than before the crisis. Our results indicate that liquidity decreased in corporate bond markets, and can help explain why despite the decrease in dealers' risk capacity, the average bid-ask spread estimates remain low.
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Conference: EFA 2017
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