Paper: “Inventory, Market Making, and Liquidity: Theory and Application to the Corporate Bond Market” (with Mahyar Kargar and Ben Lester)

Abstract: We develop a search-theoretic model of over-the-counter markets in which customers trade through dealers who face an asset-in-advance constraint; that is, when a customer and a dealer meet, we assume that dealers can only sell assets that they have previously acquired. Within this environment, we derive the equilibrium relationship between dealers’ cost of holding inventory, customers’ trading needs, and various measures of liquidity that arise endogenously, including dealers’ inventory holdings, bid-ask spreads, trading volume, and turnover. Using transaction-level data from the corporate bond market, we calibrate the model to quantitatively assess the impact of post-crisis regulations on dealers’ inventory costs, various measures of market liquidity, and welfare. We also study the extent to which non-regulated banks have substituted for traditional (regulated) dealer banks; the effects of reduced trading frictions associated with a shift towards electronic trading; and the consequences of customers shifting towards passive investment vehicles.

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