Limits to Arbitrage in Sovereign Bonds: Price and Liquidity Discovery in High-frequency Quote-driven Markets

Commonality of liquidity refers to the linkages between liquidity across assets through common market-wide factors, while liquidity discovery refers to the transmission of liquidity between assets linked to each other through arbitrage. In the context of liquidity discovery, the transmission of liquidity shocks between the two assets is supported by the actions of two types of traders: market-makers and arbitrageurs. These two types of players are motivated and constrained by distinctly different forces. This paper investigates the microstructure of the relationship between liquidity discovery, through changes in the quotes posted by market makers and the reactions of arbitrageurs, and price discovery, through the transmission of price shocks between markets.
We use data from the cash and futures markets, at the millisecond level, in the context of the Italian sovereign bond markets during the recent Euro-zone sovereign bond crisis and, surprisingly, find that: (i) 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 market makers to trade (measured by market depth and bid-ask spread), and (ii) the liquidity in the cash market, and not in the futures market, has a significant impact on the basis between the price of the futures contract and that of the cash bond that is cheapest to deliver. However, the interventions of the European Central Bank (ECB), during the Euro-zone crisis, had a significant effect on the arbitrage mechanism, and hence the lead-lag liquidity relationship between the cash and futures markets.