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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.
Safe Asset Shortages: Evidence from the European Government Bond Lending Market
1Georgetown University; 2European Central Bank
The European government bond lending market, as a core short-term funding market, not only facilitates short-selling, but also plays a unique role in allowing borrowers to access safe assets especially with relatively low-quality noncash collateral in market stress. This feature is important since it increases the velocity of safe assets and hence relieves the concern of the shortage of safe assets. We provide strong evidence that safe assets have higher demand, higher borrowing cost, and higher usage of noncash collateral during the stressed market conditions. We also show that policy interventions by central banks impact the government bond lending market, and help reduce safe asset shortages by increasing confidence in peripheral country bonds and by returning sought-after safe assets to the market.
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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