Liquidity and Value in the Deep vs. Shallow Ends of Mortgage-Backed Securities Pools

We use new TRACE data to investigate the liquidity and pricing of agency mortgagebacked pass-through securities. We distinguish between two trading channels -a To-BeAnnounced (TBA) forward delivery market and a specified-pool market. Institutional specified-pool traders in the deep end of the market have easy access to the TBA market, while retail specified-pool traders in the shallow end of the market have virtually no access to this market. We first confirm that only large specified-pool transactions show strong integration with the TBA market in terms of settlement dates and prices. We then show that TBA access for traders in the deep end translates into abundant liquidity with balanced two-way trade flow and realized bid-ask spreads of less than 0.1%. In contrast, retail traders who do not benefit from integration with the TBA market suffer 4-to-1 sell­ to-buy trade flow imbalance and 0.5% to 1% realized bid-ask spreads. Because trading in the same security can occur in both the shallow and deep ends of the market, we can estimate the price discounts due to illiquidity by comparing the prices of small and largesized trades. Our empirical tests paint a consistent picture that illiquidity in the shallow end causes 2% to 5% price discounts.