The repo market under Basel III

It's well-known that regulation can have profound effects on asset prices and market fragmentation. Yet existing evidence is very thin. We contribute by assessing the effects of Basel III on financial market fragmentation using the UK repo market as an important case study. Evidence is affirmative of a fragmentation. The leverage ratio incentivises banks to net transactions in order to mitigate the associated capital charge, which leads to a fragmentation across prices between nettable and non-nettable trades. This effect is concentrated on the bilateral segment of the market, which showcases that central counterparties insulate their members from this fragmentation. In addition, the liquidity coverage ratio incentivises banks to reduce long-term (>30 days) lending backed by lower-quality collateral, which leads to a fragmentation across maturities. Finally, the documented effects are amplified during stress as banks that are jointly constrained by both ratios reduce their activity to a greater extent than those that are constrained by a single ratio or not constrained at all, with important implications for market liquidity