Abstract
This paper investigates increased liquidity provision by market makers resulting from their ability to reduce balance sheet encumbrance through the use of central counterparties (CCPs). The introduction of the Basel III leverage rule constitutes a shock to market makers’ balance sheets and thus affects their capacity to intermediate trades. Using trade-by-trade data from sovereign bond markets, we show that liquidity provision by CCP members decreased to a lesser extent following the rule change. We attribute these findings to balance sheet reductions due to the netting enabled by CCPs, thereby highlighting their importance in cash markets.
Highlights
Central Counterparties and LiquidityTechnology and new regulations are reshaping the market microstructure of fixed income markets
A higher number of dealers on MTS are members of a central counterparties (CCPs). Consistent with this hypothesis, descriptive statistics reveal that the average volume of trades not executed via a CCP dropped by 11.2%, from EUR 31.57 million to EUR 28.42 million, after Basel III was introduced into European law
We argue that the decreased volume in the group without CCP usage is driven by banks quoting higher bid–ask spreads for balance-sheet-intensive trades
Summary
Technology and new regulations are reshaping the market microstructure of fixed income markets. Di Maggio (2017) states: “The combination of post-crisis capital and liquidity regulations and a lower return environment has made banks less able and willing to function as market makers” In this context, we investigate CCP usage and trading activity around the introduction of the leverage rule back in 2013. Adrian et al (2017) and Bao et al (2016) studied the relation between capital regulation and market-making activities and found that the capacity of banks to make markets seems to have been impaired by recent regulatory reforms such as Basel III and the Volcker Rule We contribute to this literature by showing how market makers can use CCPs to mitigate the adverse effects of regulation and how netting benefits arising from CCP usage has become more valuable when balance sheet space becomes more expensive.
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