Abstract: Does interconnectedness improve market quality? Yes. This paper develops an alternative network structure called the "assets network," where assets are connected if they are held by the same investors. Using large datasets, the study finds that interconnectedness enhances market quality, especially during stressful periods. Highly interconnected corporate bonds facilitate risk sharing and require lower compensation for risk.
Introduction: Interconnectedness, which gained prominence during the Great Financial Crisis (GFC), refers to the links between markets and institutions and their impact on the real economy. This concept is now part of regulatory frameworks. The corporate bond market, dominated by institutional investors, has seen significant growth and faces scrutiny regarding its liquidity and market functioning. The study focuses on how interconnectedness affects market quality, both in calm and stressful periods.
Network Structure: The paper introduces the "assets network," which is derived at the asset level and connects assets held by the same investors. Unlike the traditional portfolio similarity network, which captures spillovers due to overlapping portfolios, the assets network focuses on the assets themselves. This new network structure is more accurate and provides a unique perspective on financial asset connections.
Data and Methodology: The study leverages the Thomson Reuters eMAXX database to build a network of corporate bonds. It uses cosine similarity to measure interconnectedness and matches these measures with the TRACE database for trading volume, liquidity, and volatility. Rich panel regression analysis is employed to investigate the relationship between interconnectedness and market quality metrics, including spreads, liquidity, and volatility.
Key Findings:
Causality: The study aims to determine whether higher interconnectedness reduces spreads, increases liquidity, and tames volatility. While higher interconnectedness helps mitigate the effects of a shock through risk sharing, the paper notes that if the shock is too large, high interconnectedness can propagate the shock.
Conclusion: Highly interconnected corporate bonds allow for effective risk sharing and require lower compensation for risk. The study's findings contribute to the understanding of interconnectedness's role in financial markets and highlight the importance of considering interconnectedness in regulatory and supervisory frameworks.