CLO Liquidity Provision and the Volcker Rule: Implications on the Corporate Bond Market

Erstauflage 2019
ISBN: 978-3-96146-739-6
Verlag: Diplomica Verlag

Buch, Englisch, 100 Seiten, Paperback, Format (B × H): 148 mm x 210 mm, Gewicht: 157 g

Reihe: Alternative Investments23

Although it is a highly desirable feature for securities markets in order to thrive, sufficient liquidity is barely recognized when being present. This study analyzes often neglected market liquidity in the corporate bond market after the introduction of comprehensive financial regulation in the USA, foremost associated with the Volcker Rule. Research identifies an increasing share of customer liquidity provision to be a reason for an underestimation of overall transaction costs, as spreads charged by customers are lower compared to market-makers’ spreads. With customers providing liquidity where market-makers do not, the overall spread averages decrease. The author applies this research results to collateralized loan obligations (CLOs) and the corporate bond market. This approach is new, since it directly tests the growth of liquidity provision by CLOs as non-Volcker affected vehicles replacing restricted market-makers.

Autoren/Hrsg.

Klaus, Viktoria K.

Fachgebiete

• Wirtschaftswissenschaften Finanzsektor & Finanzdienstleistungen Internationale Finanzmärkte
• Wirtschaftswissenschaften Volkswirtschaftslehre Internationale Wirtschaft Internationale Finanzmärkte

Leseproben

Text sample:
Chapter 3 Fundamentals of Corporate Bond Trading and Regulatory Influences:
Due to a variety of individual features fixed income securities exhibit an inherently higher degree of complexity compared to stocks. This complexity transfers to their markets. Hence, it makes sense to portrait the characteristic features of the corporate bond market regarding its market infrastructure as well as its trading mechanics. Moreover, the impact of financial regulation on basic corporate bond market participants is elucidated. The end of chapter 3 illustrates the role of collateralized loan obligations in bond trading.
3.1 Infrastructure and Trading Mechanics of Corporate Bond Markets:
Markets bring buyers and sellers together. Both are motivated to trade by either steering risk through hedging, taking advantage of beneficial information through speculation, or rebalancing their portfolio in case of liquidity shocks. In this subchapter, different security market infrastructures are illustrated and their respective trading mechanics are compared to one another.
3.1.1 Limit Order Book and OTC Markets:
When trading securities, rules and mechanisms significantly differ depending on the form of market which in turn depends on the security traded. Auction or limited order markets represent the most automated market trading mechanics. By submitting orders, potential participants show their trading interest and a centralized, electronic trading platform automatically matches buy and sell trade requests. Conversely, in dealer markets or over-the-counter (OTC) markets, buyers and sellers find each other through an individual search, often facilitated by a market intermediary taking on this role. While stocks are typically traded on auction markets, corporate bonds are traded OTC.
On the one hand, in a limit order market, all orders are submitted to one platform, the limited order book (LOB). The LOB is a centralized ledger which stores all incoming orders until they can be matched with an offsetting trade request. Within limit order markets, two different market types need to be distinguished; in call markets, orders are executed at discrete intervals while in continuous markets trades are matched immediately - if possible. Otherwise they are also stored in the centralized LOB. Since LOB markets are highly automated, orders rely on algorithms for execution and trading decision. This reflects in the types of orders which can be submitted. Traders who value immediacy are likely to submit so called market orders that are instantly executed at the best market price available. In contrary, limit orders are only matched if a counterparty meets the asked price requirements set out by the trader who places the limit order. This might improve the execution price for the trader compared to the market price but reduces the likelihood for immediate order matching.
On the other hand, in dealer markets potential participants need to actively search for a trading partner to match their orders. Often intermediaries in form of dealers, market-makers or brokers are involved to accumulate orders and eventually reduce the search costs for traders by matching buy and sell orders. Still, with lower price transparency traders might approach multiple dealers making prices dependent on bargaining power and each participant's need for immediacy. While the former helps with reducing purchase prices (increasing sale prices), the latter aggravates price conditions, reflecting the issue of asymmetric information in OTC markets. With a higher level of an investor's sophistication, tighter bid-ask spreads are reached. Bond markets are also often referred to as quote-driven. That is, clients request quotes from dealers when they intend to place an order. Therefore, customers are dependent on dealers since they cannot place orders anonymously.
Hence, markets with a LOB are inherently faster, more transparent and after all more liquid due to the lower search and

Über Autor(innen)

Viktoria K. Klaus, M. Sc. was born in Princeton, NJ in 1995. During her Bachelor studies with focus on banking in Stuttgart, she developed her interests in financial markets. To deepen her statistical knowledge Klaus finished her master's degree at the Catholic University Eichstätt-Ingolstadt in 2018. Following her research interests in financial regulation she started an audit trainee program focusing on capital market related topics at a German bank in 2019.