Imagine that you need to sell a corporate bond. You could call a bank dealer and ask them to buy the bond from you immediately. This service, known as market making, provides immediate liquidity but relies on the bank using its own cash balance. The bank dealer holds the asset until it finds another buyer or seller, incurring a cost meanwhile. Alternatively, you could ask the dealer to search for another investor who wants to buy that bond and arrange a trade between the two of you; this service is known as matchmaking. Matchmaking is appealing because the bank dealer does not have to use its own cash, so can provide the service at a lower fee.  The downside is the lack of immediacy; finding a match takes time, so the trade isn’t instantaneous.

After the 2008 financial crisis, regulators introduced higher capital requirements, the Volcker Rule, and other measures to make banks safer. Market making became more expensive for banks as a result. Many observers worried that market liquidity would suffer. Some policymakers even embraced this perceived trade-off: the enhanced safety and soundness of banks is worth the cost of lower market liquidity.

Surprisingly, empirical evidence in the corporate bond market did not show a severe increase in overall trading costs after stricter bank regulations were put in place. While several studies found that the cost of immediate transactions increased for large bond trades, average transaction costs across all trades remained the same or even declined slightly. An interesting puzzle is if regulations made market making costlier for banks, why did average trading costs decline? 

It turns out that raising the cost of market making for banks facilitates a transition from market making to matchmaking.  Especially in the presence of competition from nonbank liquidity providers, it can lower average trading costs for customers.

To see this, it is important to look at the competitive landscape of liquidity provision. Nonbanks, such as independent broker-dealers and hedge funds, generally have higher costs of capital compared to bank dealers. Nonbanks also lack access to the central bank’s balance sheet and a broad network of customers. Partly for these reasons, banks have long dominated liquidity provision in fixed-income markets. Policies that increase capital costs for banks, but do not increase them enough to make nonbanks competitive, will lead to widening bid-ask spreads and higher costs of immediacy. 

This intuition is illustrated in Panel A of the figure below, to the left of the dashed vertical line. The blue line, representing the bid-ask spread or the cost of immediacy, goes up if banks face a higher balance sheet cost for market making. Interestingly, in this example, the customers’ average transaction cost declines slightly because some customers switch to the matchmaking service. However, they thereby incur higher costs due to delayed transactions leading to lower customer welfare (Panel C). 

However, what if regulatory costs increase further, so banks no longer have a material advantage over nonbanks? The market for immediacy becomes more competitive. Unable to keep raising the bid-ask spread without losing customers, banks reoptimize their strategy and pivot to matchmaking. Matchmaking is cheaper to provide, as it does not occupy balance sheet space. To attract more customers to matchmaking, banks need to lower their fee for matchmaking, and, as a result, the overall cost of trading declines, a higher fraction of trades happen through matchmaking, and overall trading volume increases.

This novel result is illustrated in the figure above, to the right of the dashed vertical line that represents the capital cost level above which banks endogenously reduce their matchmaking fees to compete with nonbanks’ market making activities (Panel A). As banks’ capital costs continue to increase, matchmaking accounts for a larger fraction of trades, and trading volume goes up (Panel B). Average transaction costs decline, too (Panel A). Finally, the all-in customer welfare, after deducting the cost of bid-ask spread, matching fee, and cost of delay, improves when the market structure shifts from market making to matchmaking, as illustrated in Panel C.

This study provides unique insights to regulators and policymakers. Stronger bank capital regulation did not damage market liquidity. In fact, measures that enhanced the safety and soundness of banks also improved market competition and market liquidity, thanks to the shift in market structure from market making to matchmaking.