Almost every day we read another salvo of arguments in the debate over whether bond market liquidity has been harmed by new banking regulations. Based on bid-ask spreads and most other standard liquidity metrics, bond markets appear to be about as liquid as they have been for a long time. Liquidity is worse, however, for larger-sized trades. If necessary to achieve financial stability, this is a cost well worth bearing.

The amount of liquidity offered to bond markets by large banks is markedly reduced. Large banks are stocking much smaller market-making inventories of bonds. Balance sheet space is treated like expensive real estate, available only to positions that can afford to pay rental fees that are now much higher.In the case of repurchase agreements, known as repos, access to bank balance-sheet space has been sharply increased by regulation. The three-month U.S. treasury-secured repo rates paid by non-bank dealers are now even higher than three-month unsecured borrowing rates paid by banks, a significant market distortion. Trade volume in the bank-to-non-bank dealer market for U.S. government securities repo is less than half of 2012 levels. European repo market liquidity has also deteriorated.

Repo market efficiency is an important ingredient in the general liquidity of developed bond markets. I will suggest some policy changes in this area, and discuss the implications of other ongoing changes in bond market structure, such as the changing roles of high-frequency trading and electronic trade platforms.