Sovereign Credit Risk, Liquidity, and ECB Intervention: Deus Ex Machina?

Abstract

This paper explores the interaction between credit risk and liquidity, in the context of the intervention by the European Central Bank (ECB), during the Euro-zone crisis. The laboratory for our investigation is the Italian sovereign bond market, the largest in the Euro-zone. We use a unique data set obtained from the Mercato dei Titoli di Stato (MTS), which provides tick-by-tick trade and quote data from individual broker-dealers. Our database covers the sovereign bonds of most European-zone countries, for the period June 1, 2011 to December 31, 2012, which includes much of the Euro-zone crisis period.We document a strong and dynamic relationship between changes in Italian sovereign credit risk and liquidity in the secondary bond market, conditional on the level of credit risk, measured by the Italian sovereign credit default swap (CDS) spread. We demonstrate the existence of a threshold of 500 basis points (bp) in the CDS spread, above which there is a structural change in this relationship. Other global systemic factors also affect market liquidity, but the specific credit risk of primary dealers plays only a modest role in affecting market liquidity, especially under conditions of stress.Moreover, the data indicate that there is a clear structural break following the announcement of the implementation of the Long-Term Refinancing Operations (LTRO) by the European Central Bank (ECB) on December 8, 2012. The improvement in liquidity in the Italian government bond market strongly attenuated the dynamic relationship between credit risk and market liquidity. The only variable that continues to have an impact on market liquidity is the global funding liquidity variable: the Euro-US Dollar cross-currency basis swap, a measure of Eurozone-wide macro-liquidity. Thus, the ECB intervention was successful in ameliorating both credit risk and illiquidity.Keywords: Liquidity, government bonds, financial crisis, MTS bond market JEL Classification: G01, G12, G14. * Ca' Foscari University of Venice and Goethe University Frankfurt, Stern School of Business at New York University, Copenhagen Business School, and Waseda University, respectively. We thank Einaudi Institute of Economics and Finance, the NYU Stern Center for Global Economy and Business, and the NYU-Salomon Center for financial Support. We thank Monica Billio, Rohit Deo, Rama Cont, Clara Vega and participants at the CREDIT 2013 Conference, Venice, for their insightful comments on a previous draft of this paper. We thank Stefano Bellani, Mitja Blazincic, Alberto Campari, Alfonso Dufour, Carlo Draghi, Peter Eggleston, Sven Gerhardt, and Davide Menini for sharing their thorough understanding of market practice with us. We also thank the MTS group for providing us with access to their tick-by-tick trade and quote database and, in particular, Simon Linwood and Christine Sheeka, for their assistance in interpreting the data. The views expressed in the paper are those of the authors and are not necessarily reflective of the views of the MTS group. We are responsibl...

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