I often stress the importance of liquidity – and the liquidity premium! – in financial markets and every now and then somebody scoffs that the concept of liquidity is completely bogus.
So I’m bookmarking this paper by Darrell Duffie, titled Dealer capacity and US Treasury market functionality, for future reference:
Summary
Focus
We investigate the dynamics of liquidity in the US Treasury market. In particular, we focus on the relationship between yield volatility and Treasury market illiquidity and highlight how limited dealer intermediation capacity worsens market illiquidity beyond yield volatility, but only at high levels of dealer balance sheet utilisation, as in March 2020.Contribution
The status of US Treasury securities as the world’s premier safe haven rests in part on the depth and liquidity of the market in which they are traded. Our results shed new light on the dependence of market liquidity on asset volatility and dealer intermediation capacity, and adds focus to ongoing policy efforts to improve the resilience of the US Treasury market, an anchor of global capital markets.Findings
This study combines highly relevant data on dealer-level balance sheet positions and comprehensive transaction-level Treasury security trades, among other data sets, to show that there is a significant loss in US Treasury market functionality when intensive use of dealer balance sheets is needed to intermediate bond markets, as in March 2020. While yield volatility explains most of the variation in Treasury market liquidity over time, when dealer balance sheet utilisation reaches sufficiently high levels, liquidity is much worse than predicted by yield volatility alone. This is consistent with the existence of occasionally binding constraints on the intermediation capacity of bond markets.Abstract
We show a significant loss in US Treasury market functionality when intensive use of dealer balance sheets is needed to intermediate bond markets, as in March 2020. Although yield volatility explains most of the variation in Treasury market liquidity over time, when dealer balance sheet utilization reaches sufficiently high levels, liquidity is much worse than predicted by yield volatility alone. This is consistent with the existence of occasionally binding constraints on the intermediation capacity of bond markets.
