Bank of England publishes staff working paper on investors as a liquidity backstop in corporate bond markets

The Bank of England published Staff Working Paper No. 1,126 examining how investors provide liquidity to dealers in the UK corporate bond market and how this affects trading costs and market functioning during stress. The paper finds that investor-provided liquidity can ease dealers’ balance sheet constraints, and that during the March 2020 “Dash-for-Cash” transaction costs rose by 38% in bonds where investors stopped providing liquidity. Using MiFID II transaction reports that identify both counterparties, the authors classify “client-sourced liquidity” trades where dealers unwind positions by trading with another client within the day. These trades account for around 17% of dealer-to-client trading, with “fast” client-sourced liquidity trades (second leg within 15 minutes) about 5%, and they occur more often in riskier and larger trades. Pricing patterns indicate dealers compensate liquidity-providing clients, with price improvements on the second leg concentrated in fast trades, and the paper argues outcomes depend on the composition of liquidity providers, with flexible-mandate investors such as hedge funds linked to greater resilience to liquidity shocks while reliance on constrained investors such as insurers is associated with larger increases in trading costs. It also estimates that dealers offer ongoing discounts to reward past liquidity provision to sustain liquidity-provider networks, and that these discounts make up around two thirds of broader relationship discounts. The Bank of England notes that staff working papers present research in progress and are published to elicit comments and debate.