ON 09. DEC 2022
BY THOMAS K. POULSEN
The Bank of England (BoE) recently intervened in the UK government bond market to restore market functioning. The bond market faced severe selling pressure in September 2022 after the government proposed vast unfunded tax cuts. Rapidly decreasing bond prices forced UK pension funds to post more cash collateral on their derivative positions. To raise this cash, pension funds sold UK government bonds thereby decreasing bond prices even further resulting in a self-reinforcing cycle. The BoE ultimately stepped in as a buyer of last resort to break the cycle and restore orderly market conditions.
This turmoil in the UK government bond market demonstrates the importance of liquidity in financial markets. Liquidity is the ability to trade securities at fair prices and on short notice. When liquidity is low, investors that sell securities tend to push down transaction prices. The lack of liquidity can make markets freeze up entirely and threaten financial stability. This concern is what forced the BoE to intervene.
A fundamental feature of financial markets is that every trade involves a buyer and a seller. Buyers and sellers, however, may not be present in the market at the same time. In this case, dealers play a key role in intermediating trades and have a dual capacity. First, dealers have a market-making role when they temporarily warehouse securities in their inventories. Second, dealers have a match-making role when they locate offsetting counterparties before executing a trade.
Liquidity provision in bond markets changed substantially after the 2007--2009 financial crisis. Post-crisis regulatory reforms, aimed at improving the resilience of the financial sector, disincentives dealers from holding large inventories. Dealers therefore increasingly switch from a market-making to a match-making role. This change in behavior implies that dealers are less willing to act as shock absorbers by taking bonds into inventory when faced with large selling pressure. Instead, liquidity provision relies more on dealers’ ability to locate buyers. When there are many sellers and few buyers, prices can decrease rapidly as the UK example illustrates. The BoE’s decision to carry out temporary purchases of UK government bonds therefore directly aimed at improving liquidity.
Central banks do not only use targeted asset purchases to mitigate temporary liquidity shocks. Large-scale central bank purchases of financial securities - quantitative easing (QE) - is a defining feature of monetary policy after the 2007--2009 financial crisis. The ultimate objective of QE is to stimulate the economy by reducing borrowing costs. After more than a decade of QE, the combined balance sheet of the Federal Reserve, the European Central Bank, and the BoE increased dramatically from 2.3 €trillion in 2007 to 17.5 €trillion in 2021. As a result, these central banks currently own 30--40% of their domestic government bonds.
With inflation climbing to multi-decade highs in 2022, central banks started raising monetary policy rates and terminated QE to rein in inflation. Obstfeld  recently warned that the combined effect of synchronous rate rises around the world could lead to an unnecessarily harsh contraction for the world economy. A similar concern may extend to the near simultaneous unwinding of QE by three major central banks. For example, Rajan and Acharya  emphasize the link between QE and liquidity while Rangvid  highlights liquidity implications of both QE and post-crisis regulation.
The termination of QE means that large buyers of financial securities now exit the markets. This decision makes it more challenging for dealers to locate buyers especially in times of severe selling pressure. Recent measures of deteriorating liquidity in the US, UK, and European bond markets raise concerns over new potential episodes of financial turmoil. Such episodes can have global spillover effects like the turmoil in the UK government bond market that quickly spread to other financial markets. With limited inventory capacity of dealers, central banks may therefore need to step in again as buyers of last resort. In the near future, governments also need to finance deficit spending, higher interest payments, and repay maturing debt. An interesting question is therefore: who is going to buy the debt and at what price now that central banks exit the markets?
 Obstfeld (2022): Uncoordinated monetary policies risk a historic global slowdown, available at https://www.piie.com/blogs/realtime-economic-issues-watch/uncoordinated-monetary-policies-risk-historic-global-slowdown
 Rajan and Acharya (2022): Where has all the liquidity gone?, available at https://www.diplomaticourier.com/posts/where-has-all-the-liquidity-gone
 Rangvid (2022): Where is the liquidity?, available at https://blog.rangvid.com/2022/10/30/where-is-the-liquidity/