From Market Making to Matchmaking: Does Bank Regulation Harm Market Liquidity?

The article analyzes how postcrisis bank regulations, which increased market-making costs for bank-affiliated dealers in over-the-counter (OTC) corporate bond markets, affect investor welfare and market structure. It develops a model featuring two trading mechanisms—market making (immediacy via dealer balance sheets) and matchmaking (searching for counterparties)—and two types of dealers: bank-affiliated (subject to regulatory costs) and nonbank-affiliated (not subject to such costs). The study finds that higher regulatory costs raise market-making spreads but incentivize bank dealers to shift toward matchmaking, intensifying competition from nonbank dealers and potentially lowering overall transaction costs and improving customer welfare despite longer execution times. Extensions of the model confirm the robustness of these results under various competitive settings, including when nonbank dealers also offer matchmaking and when multiple dealers compete. The findings align with empirical observations of increased matchmaking and changing dealer market shares postcrisis, suggesting that regulatory reforms can foster a more efficient market structure by promoting competition and alternative liquidity provision methods.