Adverse-selection considerations in the market-making of corporate bonds

Abstract

We examine the effect of adverse selection considerations in the market-making of investment-grade corporate bonds. Our sample consists of bonds participating in the JP Morgan’s JULI index that represents the most traded subset of the market. We find that customer trades executed in the wholesale market segment are more informative than trades executed in the retail-market. However, this asymmetry is not reflected in transaction costs but only seems to affect the dealers’ learning process. Our evidence suggests that the dealers’ tendency to treat as more informative wholesale customer trades translates into statistically significant economic benefit. Moreover, when information asymmetry favors market-makers, we find that the latter perform better than usual. In particular, our evidence suggests that a significant portion of the dealers’ profits stems from their ability to exploit efficiently the arrival of public information.