The Linkage between Primary- and Secondary-Markets for Eurozone Sovereign Debt: Free Flow or Bottleneck?
Posted: 27 Jan 2018 Last revised: 5 Oct 2018
Date Written: September 19, 2018
In this paper, we investigate the consequences of interlinked sovereign bond markets in the Eurozone for the transmission of yields and market conditions. This linkage is established by ﬁnancial intermediaries, the so-called primary dealers, who participate in sovereign bond auctions, and are also active as market makers in the secondary markets of multiple countries. We develop a model of ﬁnancially constrained primary dealers that would like to buy newly issued bonds and may consider to sell a proportion of their existing inventory, while providing liquidity in the secondary market at the same time. Our model produces optimal inventory levels for the existing- and the newly issued bonds that can be related to predictable price movements around sovereign bond issuances. The optimal inventory levels depend on the cost of inventory and regulatory capital, prevalent funding conditions, and demand volatility of the existing- and the newly issued bond. We empirically analyze how market conditions, individual bond characteristics and the existence of common intermediaries aﬀect the relation between the primary- and secondary markets in the form of predictable price changes, as well as quoted and traded volumes. We ﬁnd that primary dealers tend to liquidate more liquid and more risky bonds ﬁrst in order to minimize the impact of sovereign bond auctions on their liquidation cost and their portfolios. Furthermore, lower liquidity and higher risk of the auctioned bond may lead to a higher impact of sovereign bond auctions on the secondary market and, thus, on the portfolios of primary dealers. Last, funding conditions and the basis risk, i.e., hedging capacities, may also aﬀect the ability of primary dealers to participate in these auctions.
Keywords: Eurozone, Financial Intermediation, Sovereign Bond Market
JEL Classification: G12, G15, G23, H63
Suggested Citation: Suggested Citation