Illiquidity, concentrated bond holding raise volatility – paper

Financial market illiquidity and concentrated holdings of bonds aggravate price volatility in periods of stress, a paper published by The Netherlands Bank argues.

In A shock to the system? Market illiquidity and concentrated holdings in European bond markets, Sophie Steins Bisschop, Martijn Boermans and Jon Frost analyse recent periods of financial market volatility.

They use the "new and unique" securities holding statistics sectoral database compiled by the European Central Bank, as well as price and liquidity data from multiple sources. This enables the authors, they say, to test the impact of market illiquidity and bond-holding concentration on price shocks.

They focus on the 2013 ‘taper tantrum' and the 2015 ‘Bund tantrum'. Market illiquidity was a "strong and statistically significant driver of price volatility" in both episodes, the authors say. Bond-holding concentration significantly increased volatility in the latter, they add.

The authors list several possible measures to reduce volatility caused by these factors, including counter-cyclical margin requirements, stress tests of asset managers and the extension of the large exposure regime to illiquid markets.