Liquidity Determinants in the UK Gilt Market

Abstract

We use proprietary transactional data to examine the determinants of liquidity in the UK government bond (gilt) market, over a rich sample period that covers both the financial crisis of 2008–09 as well as the onset of the subsequent euro-zone sovereign debt crisis. During this period, gilt market liquidity fluctuates significantly with execution costs almost doubling at the peak of the crisis. Consistent with theory, dealer balance sheet constraints and increased funding costs are significant determinants of illiquidity. However, we document that increased funding costs also negatively impact the inter-dealer segment of the market which leads to a further reduction in liquidity. This is consistent with the notion that the inter-dealer segment enables dealers to share risk and manage their inventories. Additionally, gilt market illiquidity is also influenced by instances of reduced competition among dealers. Both of these effects are more pronounced at the peak of the financial crisis and economically significant: a one standard deviation decrease in the fraction of inter-dealer trading leads to an increase in trading costs of about $700K–$1.5 million daily for non-dealers, and a one standard deviation increase in dealer activity concentration leads to an incremental cost of about $270K–$1 million daily.

Keywords: Gilt market, market liquidity, funding liquidity, inter-dealer trading, competition

JEL Classification: G10, G12, G14