The Value of Trading Relationships in Turbulent Times

Abstract

This paper investigates the ways in which the network of relationships between dealers shapes their trading behavior in the corporate bond market. They charge lower spreads to dealers with whom they have the strongest ties, and this effect is all the more pronounced at times of market turmoil. Moreover, highly connected and systemically important dealers exploit their connections at the expense of peripheral dealers as well as clients, charging higher markups than to other core dealers, especially during periods of uncertainty. We show that following the collapse of a flagship dealer in 2008, trading chains lengthened by almost 20 percent and that the increase was even greater for the institutions that had the closest ties with the defaulted dealer. Finally, we find evidence that dealers drastically reduced their inventory during the financial crisis. These results can help inform the debate on the risks posed by the interconnectedness of the financial system, showing how this could be a source of market fragility and illiquidity.