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Sovereign credit risk, liquidity, and ECB intervention: Deus ex machina?

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  • Pelizzon, Loriana
  • Subrahmanyam, Marti G.
  • Tomio, Davide
  • Uno, Jun

Abstract

This paper examines the dynamic relationship between credit risk and liquidity in the sovereign bond market in the context of the European Central Bank (ECB) interventions. Using a comprehensive set of liquidity measures obtained from a detailed, quote-level dataset of the largest interdealer market for Italian government bonds, we show that changes in credit risk, as measured by the Italian sovereign credit default swap (CDS) spread, generally drive the liquidity of the market: a 10% change in the CDS spread leads a 11% change in the bid-ask spread. This relationship is stronger, and the transmission is faster, when the CDS spread is above the 500 basis point threshold, estimated endogenously, and can be ascribed to changes in margins and collateral, as well as clientele effects. Moreover, we show that the Long-Term Refinancing Operations (LTRO) intervention by the ECB weakened the sensitivity of the liquidity provision by the market makers to changes in the Italian government's credit risk. We also document the importance of market-wide and dealer-specific funding liquidity measures in determining the market liquidity for Italian government bonds.

Suggested Citation

  • Pelizzon, Loriana & Subrahmanyam, Marti G. & Tomio, Davide & Uno, Jun, 2015. "Sovereign credit risk, liquidity, and ECB intervention: Deus ex machina?," SAFE Working Paper Series 95, Research Center SAFE - Sustainable Architecture for Finance in Europe, Goethe University Frankfurt.
  • Handle: RePEc:zbw:safewp:95
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    Cited by:

    1. Loon, Yee Cheng & Zhong, Zhaodong (Ken), 2016. "Does Dodd-Frank affect OTC transaction costs and liquidity? Evidence from real-time CDS trade reports," Journal of Financial Economics, Elsevier, vol. 119(3), pages 645-672.
    2. Anne-Laure Delatte & Julien Fouquau & Richard Portes, 2017. "Regime-Dependent Sovereign Risk Pricing During the Euro Crisis," Review of Finance, European Finance Association, vol. 21(1), pages 363-385.
    3. Schneider, Michael & Lillo, Fabrizio & Pelizzon, Loriana, 2016. "How has sovereign bond market liquidity changed? An illiquidity spillover analysis," SAFE Working Paper Series 151, Research Center SAFE - Sustainable Architecture for Finance in Europe, Goethe University Frankfurt.
    4. Ehrmann, Michael & Fratzscher, Marcel, 2017. "Euro area government bonds – Fragmentation and contagion during the sovereign debt crisis," Journal of International Money and Finance, Elsevier, vol. 70(C), pages 26-44.
    5. Paul Mizen & Veronica Veleanu, 2015. "On the Information Flow from Credit Derivatives to the Macroeconomy," Discussion Papers 2015/21, University of Nottingham, Centre for Finance, Credit and Macroeconomics (CFCM).
    6. Abudy, Menachem Meni & Raviv, Alon, 2016. "How much can illiquidity affect corporate debt yield spread?," Journal of Financial Stability, Elsevier, vol. 25(C), pages 58-69.

    More about this item

    Keywords

    Liquidity; Credit Risk; Euro-zone Government Bonds; Financial Crisis; MTS Bond Market;

    JEL classification:

    • G01 - Financial Economics - - General - - - Financial Crises
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G14 - Financial Economics - - General Financial Markets - - - Information and Market Efficiency; Event Studies; Insider Trading

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