The bond dealers in these over-the-counter markets are called broker-dealers. They tend to be large investment banks, though hedge funds and high-frequency traders can also act as broker- dealers.
These bond dealers in the over-the-counter market serve the role of market makers. A market maker is an entity that is willing to quote a price to buy or sell a security at any time—even if the market maker doesn’t have another buyer lined up. They make money on the difference between the bid and ask prices they display—this is known as a bid-ask spread. This compensates them for the risk that the securities they buy and hold in their inventories will drop in value before they find a buyer.
Because there is a much lower volume of bond trades than stocks, market makers play a particularly crucial role in bond markets by providing liquidity. Liquidity is the ability to buy or sell a security quickly without having to take a penalty in terms of price. Without a market where investors can sell their bonds before their maturity date, investors would be hesitant to tie up large amounts of money in bonds for an extended period of time. (Few people would buy a 30-year Treasury Bond if they had to hold it for all 30 years.) This would reduce the overall amount of money available to borrow in the bond market, which in turn would make borrowing more expensive.
Market makers in stocks generally never leave the playing field, but because bonds don’t trade on exchanges with set rules, market makers in bonds have the option of leaving the market any time. When this occurs, liquidity can disappear. We saw this during the financial crisis, when markets for mortgage-backed securities—bonds backed by mortgages from across the country—dried up very quickly.
The bond markets may be changing
Electronic trading has revolutionized stock trading, and some hope it will revolutionize bond trading as well. There have been many efforts made by bond traders to move secondary market activity to electronic platforms and exchanges to improve liquidity. While there have been a variety of proprietary electronic platforms where investors can see bid and ask prices for bonds in a broker-dealer’s inventory, the most popular platforms are multi-dealer platforms. These platforms allow investors to get bid and ask quotes from multiple broker-dealers and other market participants, including institutional investors. MarketAxess—an independent multi-dealer platform connecting investors with a number of broker-dealers—is the most popular, with 13% of all corporate bond trades taking place there.11
Trades on multi-dealer platforms have been increasing each year, which is a positive step in adding liquidity to secondary markets. Yet the move to electronic trading has been gradual, and it is not clear how much of the market will move in this direction. Treasury bonds are mostly traded on electronic platforms, but most other bonds are still traded over the counter, and there remains a lack of liquidity and transparency in secondary bond markets compared to stock markets. It can still be hard to find bid and ask prices for some bonds—particularly complex bonds and lower-grade corporate bonds.