1. 1 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, Queens University, Belfast

2. © Harald Hau, INSEAD 2 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

3. © Harald Hau, INSEAD 3 Dealer Intermediation Dealer 1 Dealer 3 Dealer 2 Customers B2B B2C

4. © Harald Hau, INSEAD 4 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)?

5. © Harald Hau, INSEAD 5 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

6. © Harald Hau, INSEAD 6 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)

7. © Harald Hau, INSEAD 7 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)

8. © Harald Hau, INSEAD 8 Summary on Market

9. © Harald Hau, INSEAD 9 Italian/Non-Italian B2B and B2C Segment Italian Benchmark Bonds

10. © Harald Hau, INSEAD 10 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

11. © Harald Hau, INSEAD 11 Cross-market Spreads by Bond Type Bid side B2C quality dispersion: 3.35 cents Av. B2B Spread: 1.82 cents

12. © Harald Hau, INSEAD 12 Cross-Market Spreads by Maturity

13. © Harald Hau, INSEAD 13 Cross-Market Spreads by Volatility

14. © Harald Hau, INSEAD 14 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 x t for the bid (ask) price. Innovations Δx t 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.

15. © Harald Hau, INSEAD 15 Trading Sequence

16. © Harald Hau, INSEAD 16 Dealer Problem

17. © Harald Hau, INSEAD 17 Value Function

18. © Harald Hau, INSEAD 18 Optimal B2C Quotes Relative to x t Ask (bid) side B2C prices are improved under positive (negative) dealer inventory Selling your positive inventory to customers is an advantageous way to rebalance

19. © Harald Hau, INSEAD 19 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

20. © Harald Hau, INSEAD 20 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

21. © Harald Hau, INSEAD 21 Cross Market Spread and Volatility Relative B2C market quality increase with higher risk

22. © Harald Hau, INSEAD 22 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

23. © Harald Hau, INSEAD 23 Average Cross Market Spread and Dealer Imbalances

24. © Harald Hau, INSEAD 24 Ask Side Evidence

25. © Harald Hau, INSEAD 25 Bid Side Evidence

26. © Harald Hau, INSEAD 26 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)