Fragmenting Markets

1 The Cost of Bank Balance Sheet Space 14

1.1 The setting 15

1.2 Debt overhang has risen 18

1.3 Liquidity provision by dealers 25

1.4 Modigliani-Miller and asset substitution 27

1.5 Impact on swap markets 29

1.6 Strategic implications for dealers 31

1.7 Asset pricing implications 33

1.8 The leverage-ratio rule 34

1.9 European versus U.S. banks 35

1.10 Competition and price transparency 37

1.11 The efficient stability-liquidity frontier 38

2 Leverage Rule Distortions 42

2.1 Leverage rule distortions 42

2.2 Repo intermediation under the SLR 46

2.3 SLR degrades monetary-policy passthrough 55

3 Dealer Funding Costs 59

3.1 An illustrative example: T-bill investment 60

3.2 Post-crisis increases in dealer funding costs 61

3.3 A model of dealer funding costs 64

3.4 CIP arbitrage could harm shareholders 67

3.5 Regulatory capital and the CIP basis 71

4 Market Design Implications 74

4.1 Opaque bilateral trade is inefficient 75

4.2 Multilateral trade 77

4.3 Size discovery 79

4.4 Mandating multilateral trade facilities 82

4.5 Post-trade price transparency 86

4.6 Market infrastructure 90

4.7 Compression trading 93

Bibliography 95

Darrell Duffie, Adams Distinguished Professor of Management and Professor of Finance, Stanford University, USA