Microstructure

Microstructure

Session Chair: Carole Comerton-Forde, The University of Melbourne
Discussants:
Hank Bessembinder, Arizona State University
Alfred Lehar, University of Calgary

Increasing Corporate Bond Liquidity Premium and Post-Crisis Regulations

Botao WuNew York University

I employ the liquidity premium measure to understand the important changes in corporate bond market liquidity from 2004 to 2019. I show that while commonly-used transaction cost measures such as the bid-ask spread have been declining, the corporate bond liquidity premium has actually increased since the financial crisis. For speculative bonds, about 30% of their yield spread now compensates for illiquidity compared to 15% before the crisis. I demonstrate that this increasing liquidity premium is due to investors facing longer trading delays as dealers have become less willing to provide immediacy, and develop a structural over-the-counter model to estimate the latent trading delays implied by the size of the liquidity premium. The estimation results suggest that bonds that took less than one day to sell before the financial crisis now take weeks to trade. Finally, I establish a causal relationship between the major post-crisis regulations and the variations in the corporate bond liquidity premium to uncover the potential cause of dealers' unwillingness to provide liquidity. I show that Basel II.5, by introducing the stressed value-at-risk and incremental risk charges for credit products, contributed the most to increasing the liquidity premium out of all regulatory changes examined. The longer trading delays and the impact of regulations are consistent with practitioners' descriptions of the post-crisis market and corroborate the relevance of using the liquidity premium to understand corporate bond market liquidity.
Paper

Coexisting Exchange Platforms: Limit Order Books and Automated Market Makers

Jun AoyagiThe Hong Kong University of Science and Technology
Yuki Ito, University of California, Berkeley

Blockchain-based decentralized exchanges have adopted automated market makers—algorithms that pool liquidity and make it available to liquidity takers by automatically determining prices. We develop a theoretical framework to analyze coexisting market-making structures: a traditional centralized limit-order market and a decentralized automated market. Traders face asymmetric information and endogenously choose trading venues. We show that liquidity on the automated market complements that on the limit-order market. A unique and stable general equilibrium exists with endogenous liquidity on both platforms, and we investigate the impact of adopting automated market makers on asset prices and traders' behavior.
Paper

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