Ulric B. and Evelyn L. Bray Social Sciences Seminar

Abstract: This paper shows that product attributes shape search frictions, and studies the incentives of intermediaries to leverage this channel to increase their rents in the context of the US municipal bond market. Municipal bonds may be designed via negotiations between a local government and its underwriter, and upon issuance, they are traded in an over-the-counter market. Exploiting variations in state regulations to limit government officials' conflict of interests, we provide suggestive evidence that underwriters tend to increase their market share in the secondary market trades by including special provisions to a bond. This in turn decreases the bond's liquidity as it increases search frictions. Motivated by these findings, we build and estimate a model of bond issuance and trades to quantify market inefficiency and to discuss policy implications.

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