Cash-Forward Arbitrage and Dealer Capital in MBS Markets: COVID-19 and Beyond

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Staff Reports

Dealers and the Dealer of Last Resort: Evidence from the Agency MBS Market in the COVID-19 Crisis

Previous title: “Cash-Forward Arbitrage and Dealer Capital in MBS Markets: COVID-19 and Beyond”

Number 933
July 2020 Revised February 2024

JEL classification: D8, G2

Authors: Jiakai Chen, Haoyang Liu, Asani Sarkar, and Zhaogang Song

When market disruptions started in March 2020, dealers maintained the usual liquidity provision in the agency MBS market by taking cash inventory and hedging inventory risk with forward contracts. However, cash and forward prices significantly diverged and began to converge only after the Federal Reserve deployed nonstandard purchase operations to promptly take MBS off dealers’ balance sheets. Further cross-dealer analyses point to supplemental leverage ratio requirements as major constraints on dealers’ balance sheets. Customers’ selling increased when price divergence reverted, inconsistent with conjectures of some studies. Comparisons with corporate bond markets uncover additional dealer frictions.

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Author Disclosure Statement(s)

Jiakai Chen
I, Jiakai Chen, declare that I have no relevant or material financial interests that relate to the research described in the paper titled “Cash-Forward Arbitrage and Dealer Capital in the MBS Markets: COVID-19 and Beyond,” co-authored with Haoyang Liu, Asani Sarkar, and Zhaogang Song. Prior to circulation, this paper was reviewed in accordance with the Federal Reserve Bank of New York review policy, available at https://www.newyorkfed.org/research/staff_reports/index.html.

Haoyang Liu
The author declares that he has no relevant or material financial interests that relate to the research described in this paper. Prior to circulation, this paper was reviewed in accordance with the Federal Reserve Bank of New York review policy, available at https://www.newyorkfed.org/research/staff_reports/index.html.

Asani Sarkar
The author declares that (s)he has no relevant or material financial interests that relate to the research described in this paper. Prior to circulation, this paper was reviewed in accordance with the Federal Reserve Bank of New York review policy, available at https://www.newyorkfed.org/research/staff_reports/index.html.

Zhaogang Song
The author declares that he has no relevant or material financial interests that relate to the research described in this paper.

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