Over-the-counter market liquidity and securities lending
Summary
Focus
This paper studies how securities lending affects over-the-counter market (OTC) liquidity.
Contribution
The financial crisis of 2007-09 kindled a wider interest in studies of liquidity in OTC financial markets, such as the corporate bond market. Buyers and sellers in these markets trade without centralised exchanges. The greater time and resources needed to complete trades can impede market liquidity - the ability to transact efficiently. Intermediaries, such as broker-dealers, may emerge to maintain an inventory of securities and to match buyers and sellers. Securities lending markets offer dealers a way to mitigate the consequences of frictions inherent in OTC markets. We identify and quantify the importance of securities lending of corporate bonds to market liquidity in the OTC corporate bond market.
Findings
We combine data on corporate bond market trades with data on corporate bond lending transactions and data on the individual corporate bond holdings of US insurance companies. Our empirical design carefully controls for the many confounding determinants of market liquidity. We show that the shutdown of AIG's securities lending programme in 2008 caused a reduction in the market liquidity of corporate bonds held predominantly by AIG. We also provide evidence for an important mechanism behind the decrease in corporate bond liquidity: Dealers used the inter-dealer market as an imperfect substitute for the securities lending market. In particular, we document a shift towards relatively small trades with other dealers in the inter-dealer market.
Abstract
This paper studies how over-the-counter market liquidity is affected by securities lending. We combine micro-data on corporate bond market trades with securities lending transactions and individual corporate bond holdings by U.S. insurance companies. Applying a difference-in-differences empirical strategy, we show that the shutdown of AIG's securities lending program in 2008 caused a statistically and economically significant reduction in the market liquidity of corporate bonds predominantly held by AIG. We also show that an important mechanism behind the decrease in corporate bond liquidity was a shift towards relatively small trades among a greater number of dealers in the interdealer market.
JEL classification: G01, G12, G22, G23
Keywords: over-the-counter markets, corporate bonds, market liquidity, securities lending, insurance companies, broker-dealers