1 a tale of two platforms: dealer intermediation in the european sovereign bond market cepr...
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A Tale of Two Platforms:
Dealer Intermediation in the European Sovereign Bond Market
CEPR Discussion Paper 6969
http://www.haraldhau.com
Peter Dunne, Central Bank of Ireland
Harald Hau, INSEAD
Michael Moore, Queen’s University, Belfast
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Motivation
Dual Market Structures: Interdealer Market (B2B): Dealer Segment Wholesale Market (B2C): Customer Segment
Market Quality? Customer segment is under-researched, but very important Interaction studies even more rarely
Why is it interesting? Regulatory policy issues: Should we allow a dual market? Do
customers get good market quality? When? Dealer activity is intermediation between two markets; hence
want to model and understand interaction between markets
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Dealer Intermediation
Dealer 1
Dealer 3
Dealer 2
CustomersB2B
B2C
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Three Research Questions
What is the average market quality in the B2C segment?
How big is the dispersion of B2C quotes and what determines B2C execution quality?
How does relative market quality vary with market conditions (volatility)?
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Related Research
U.S. municipal bond market: Harris and Piwowar (2006) Green, Hollifield and Schurhoff (2007)
Market quality Low average execution quality Large dispersion of transaction prices (= price discrimination?)
Why? Unsophisticated retail clients make trading errors No price transparency
European Sovereign bond market: Small banks and institutions are customers …. not retail clients
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Key Findings for European Sovereign Bond Market
B2C transactions show high quality: They are on average better than the best interdealer quotes.
This extends to non-benchmark bonds.
B2C transaction show high quality dispersion Best and worst quartile averages differ by 4.56 (5.33) cents on
the ask (bid) side relative to an average B2B spread of 4.31
More (or constant) relative B2C quality under more risk (adverse selection)
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Our Data
Dealer to Dealer (B2B) data from MTS for 3 quarters in 2005
1,369 billion Euros in volume 188,782 trades
Matched data from the MTS customer trading platform BondVision
240 billion Euros in volume 45,504 trades
Focus: Italian benchmark bonds (= best data coverage)
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Summary on Market
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Italian/Non-Italian B2B and B2C Segment
Italian Benchmark Bonds
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Measuring B2C Transaction Quality
Cross-market spread: Positive measure of price improvement of B2C transaction over best B2B quote on the same side of the market
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Cross-market Spreads by Bond Type
Bid side B2C quality
dispersion: 3.35 centsAv. B2B Spread: 1.82 cents
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Cross-Market Spreads by Maturity
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Cross-Market Spreads by Volatility
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Model of Dealer Intermediation
Dealers have monopolistic customer (B2C) relationships and are allowed to have inventories of -1,0,+1
Customers arrive stochastically for a transaction quantity of +1 (or -1) with uniform reservation price distribution above (below) the stochastic value xt for the bid (ask) price. Innovations Δxt are binomial in each trading round.
Dealers have to rebalance in the B2B market immediately if their holdings are above +1 or below -1. The B2B market is competitive and there is always at least one dealers with opposite holding to rebalance.
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Trading Sequence
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Dealer Problem
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Value Function
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Optimal B2C Quotes Relative to xt
Ask (bid) side B2C prices are improved under positive (negative) dealer inventory
Selling your positive inventory to customers is an advantageous way to rebalance
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B2B Equilibrium Condition
B2B price is such that the dealer (with the opposite inventory balance) is indifferent between being hit or not
The adverse selection risk from B2B quote provision is
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Existence of a Stable Equilibrium in B2B and B2C
B2C: Higher B2B speads inventory constrains more costly
Convexity of value function larger
B2B: Higher B2B spreads Come with more adverse
selection loss in B2B High value convexity makes B2B
submission more attractive
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Cross Market Spread and Volatility
Relative B2C market quality increase with higher risk
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Aggregate Imbalances
Would like to estimate model on dealer inventory balances, but not these are not available
Model: Know that dealers with extreme imbalances will quote the best B2B prices on the other side of the market in order to passively rebalance
Hence can infer aggregate dealer imbalances from the market depth at the best bid or ask
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Average Cross Market Spread and Dealer Imbalances
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Ask Side Evidence
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Bid Side Evidence
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Summary
Literature: B2C market have low average transaction quality and high quality dispersion, possibly because of
Lacking customer sophistication (trading errors) Lack of price transparency Price discrimination across customers
European sovereign market High average transaction quality But still high B2C price dispersion Show that inventory constraints are important in explaining B2C
market quality, possibly more than discriminatory pricing B2C market quality better under high risk (incomplete risk pass-
through)