Sovereign Credit Risk, Liquidity and ECB Intervention: Deus ex Machina?

This paper explores the interaction between credit risk and liquidity, in the context of the intervention by the European Central Bank (ECB), during the Euro-zone crisis. The laboratory for our investigation is the Italian sovereign bond market, the largest in the Euro-zone. We use a unique data set obtained from the Mercato dei Titoli di Stato (MTS), which provides tick-by-tick trade and quote data from individual broker-dealers. Our database covers the period June 1, 2011 to December 31, 2012, which includes much of the Euro-zone crisis period. We document a strong and dynamic relationship between changes in Italian sovereign credit risk and liquidity in the secondary bond market, conditional on the level of credit risk, measured by the Italian sovereign credit default swap (CDS) spread. We demonstrate the existence of a threshold of 500 basis points (bp) in the CDS spread, above which there is a structural change in this relationship. Other global systemic factors also a ffect market liquidity, but the speci c credit risk of primary dealers plays only a modest role in a ffecting market liquidity, especially under conditions of stress.
Moreover, the data indicate that there is a clear structural break following the announcement of the implementation of the Long-Term Re nancing Operations (LTRO) by the European Central Bank (ECB) on December 8, 2012. The improvement in liquidity in the Italian government bond market strongly attenuated the dynamic relationship between credit risk and market liquidity. Thus, the ECB intervention was successful in ameliorating both credit risk and illiquidity.