Bank of England working paper finds repo dealer market power and network shocks drive UK gilt mispricing

The Bank of England published Staff Working Paper No. 1,145 analysing proprietary UK bond and repo market data to quantify how funding-market frictions affect gilt pricing and market-wide liquidity. The paper estimates that frictions linked to individual dealer market power account for around 0.5 to 1.3 percentage points of bond price deviations, while the transmission of heterogeneously persistent shocks between dealers accounts for around 2 to 4 percentage points. Using transaction-level repo and reverse repo data from 2016 to 2022, the authors link mispricing and liquidity conditions to (i) dealers’ ability to set bilateral over-the-counter (OTC) spreads and quantities away from competitive benchmarks and (ii) propagation of persistent dealer shocks through the trading network. A more uneven distribution of bargaining power across dealers is associated with lower market-wide liquidity and larger deviations of gilt prices from benchmark values, with stronger effects in the reverse repo segment where demand for scarce collateral from hedge funds and asset managers amplifies scarcity premia. Persistent shocks to influential reverse-repo dealers increase mispricing, while persistent shocks to influential repo dealers reduce it; transitory shocks are found to have materially smaller effects. The paper argues that these results point to the need for tools to address core funding-market frictions, including monitoring primary dealers and key non-bank institutions and improving transparency in bilateral OTC segments, particularly as central bank balance sheets normalise.