Limits to Arbitrage in Sovereign Bonds Price and Liquidity Discovery in High Frequency Quote Driven Markets

The progressively stronger linkages across markets, due to faster access to information and trade execution, cause market liquidity to be rapidly transmitted across markets. In contrast to the resultant commonality of liquidity across markets that are affected by common market-wide factors, the transmission of liquidity between markets linked to each other through arbitrage, such as cash bond and futures markets, which we term liquidity discovery, is likely to be even stronger. This paper investigates the microstructure of the relationship between price discovery, the transmission of price shocks between markets, and liquidity discovery, the transmission of liquidity shocks, through changes in the quotes posted by market makers and the reactions of arbitrageurs. Our analysis is in the context of the Italian sovereign bond cash and future markets, during the recent Euro-zone sovereign bond crisis. Data provided by the Mercato dei Titoli di Stato (MTS),
for the cash bonds, and Reuters, for the futures contracts, allow us to investigate, at the millisecond level, the quoted book in both the cash and futures markets. We show that even though the futures market leads the cash market in price discovery, the cash market leads the futures market in liquidity discovery, i.e., the willingness of the market makers to trade (measured by market depth as the key liquidity measure). More specifically, the liquidity in the cash market also has a significant impact on the changes in the basis (and therefore, the limits to arbitrage) between the prices of the futures contract and the cash bond that is cheapest to deliver. However, the European Central Bank (ECB) intervention through the Long Term Refinancing Operations (LTRO) had an effect on the arbitrage relationship, fostering the convergence of the basis to zero, and therefore, helping close the gap in the lead-lag liquidity relationship between the cash and the future markets.