When David becomes Goliath: Repo dealer-driven bond mispricing

TL;DR

This paper investigates how dealer market power and their linkages create bond mispricing and liquidity issues, quantifying their impact on bond yields using detailed transaction data.

Contribution

It introduces a novel analysis of dealer market power and inter-dealer linkages as sources of bond mispricing and liquidity frictions, supported by proprietary transaction data.

Findings

Dealer market power accounts for 0.5-1.3 percentage points of yield deviation.

Dealer linkages transmit shocks causing 2-4 percentage points of yield deviation.

Market frictions significantly influence bond pricing and liquidity.

Abstract

This paper studies the impact of funding market frictions on bond prices and market-wide liquidity. Using proprietary transaction-level data on all gilt-backed repo and reverse-repo trades, we demonstrate how the market power of individual dealers and their linkages generate frictions. Specifically, we show that frictions related to market power account for between 0.5 and 1.3 percentage points of bond yield deviation, while the transmission of heterogeneously persistent shocks between dealers accounts for between 2 and 4 percentage points of yield deviation.