The Liquidity of the Government Bond Market — What Impact Does Quantitative Easing Have? Evidence from Sweden

Q1. What are the five liquidity measures and how are they constructed from MiFID transaction data?

The paper derives five measures from 316,413 filtered dealer-to-client and dealer-to-dealer transactions (out of 802,102 raw transactions) covering Swedish nominal government bonds from 2015 to 2020 under MiFID I and II reporting obligations. Tightness is captured by Yield Impact (YI), defined as the price change per trade divided by time to maturity — higher YI signals lower transaction costs per unit of duration. Immediacy and breadth are captured by Turnover (TURN, total volume traded weekly) and Turnover Ratio (TR, volume as a fraction of outstanding). Resilience is captured by Market Efficiency Coefficient (MEC) and Volume-Adjusted Imputed Volatility (VAIV): MEC compares return variance over long and short horizons — a ratio near one signals efficient absorption of order flow; VAIV measures price volatility after adjusting for volume, so that higher VAIV signals less efficient price formation per unit of trading. These five dimensions track different aspects of market quality and do not always move together, which is why using a single measure would miss the full picture.

Q2. What is the demand effect of QE purchases, and how large is it relative to the scarcity effect?

The demand effect captures the temporary improvement in liquidity on the week of a central bank purchase, measured by the coefficient on the contemporaneous Riksbank purchase variable; it is positive and significant for four of the five measures (TURN, TR, YI, and VAIV), but not for MEC. In the baseline regression (Table 3, Panel 1), a one standard deviation increase in outright purchases increases YI by approximately 4.4 standard deviations. However, this is a one-time event: the coefficient on purchases captures the effect at time t only, and the paper confirms that liquidity in the subsequent week is not significantly affected by prior purchases. By contrast, the scarcity (holding) effect from accumulated bond stock is persistent: at average holding levels of approximately 36 percent of outstanding, the holding variable decreases YI by 0.15 basis points from an average level of around 1.17 basis points per transaction. The scarcity effect is therefore approximately five times larger than the demand effect at these holding levels, and lasts as long as the central bank holds the bonds — effectively until maturity.

Q3. What is the nonlinearity in the scarcity effect and how is the 40 percent threshold identified?

The threshold is identified from a bond-by-bond analysis of the Debt Management Office’s Securities Lending Facility (SLF) usage: both the volume and volatility of SLF activity increase significantly when the Riksbank’s holding share crosses approximately 40 percent of outstanding for a given bond, indicating that market participants seek alternative sources of bond supply precisely at that concentration level. The paper re-estimates the baseline model on two subsamples — bonds with holding below 40 percent and bonds with holding above 40 percent. Below the threshold, neither the demand effect nor the scarcity effect is significant for most measures (all purchase coefficients become insignificant except MEC, which turns negative; all holding coefficients are insignificant except TR which turns negative). Above the threshold, the demand effect strengthens (intuition: with fewer free-float bonds, the marginal impact of a purchase on liquidity is amplified), and the scarcity effect on YI is approximately four times larger than in the baseline. Volume-based turnover measures (TURN and TR) do not show significant scarcity effects above the threshold, suggesting that the scarcity effect concentrates on transaction costs and price efficiency rather than traded volumes when the holding share is large.

Q4. Does the Securities Lending Facility offset the scarcity effect?

The SLF coefficient is consistently positive across all five measures, and statistically significant for YI and VAIV in the baseline, suggesting the facility partially restores liquidity by lending bonds to market makers when the central bank’s holdings reduce free-float supply. However, the SLF does not significantly improve the volume-based measures (TURN and TR), and the effect is only detectable above the 40 percent threshold for turnover measures. The paper orthogonalizes SLF volumes against the Holding variable (to address the 50 percent pooled correlation between them) and finds no material change in the holding coefficients. The interpretation is that the SLF provides a buffer against scarcity-driven deterioration in transaction costs and price efficiency, but it does not fully restore pre-QE liquidity levels when holding shares are high. The paper also notes that the SLF may set a floor for short-term market interest rates relative to the policy rate, partially offsetting QE’s effect on yields — a second-order consideration for the liquidity analysis but relevant for the broader QE transmission mechanism.

Q5. Why does bond market liquidity not respond to QE announcements?

The paper tests whether QE announcement dates predict liquidity improvements and finds that they do not: liquidity responds only to actual purchases, not to forward-looking price adjustments at announcement. This contrasts with asset prices, which are forward-looking and respond immediately to announced changes in the expected path of central bank asset holdings. Bond market liquidity depends on the physical quantity of bonds available for trading, which changes only when purchases are executed, not when they are anticipated. This asymmetry has a policy implication: policymakers cannot exploit an announcement effect to improve market liquidity in advance of purchases, and the liquidity costs of QE (the scarcity effect) accumulate gradually over the purchase period rather than being front-loaded at announcement.

Q6. How robust are the results to time aggregation, time fixed-effects, outliers, and alternative specifications?

The baseline results are robust across six groups of robustness checks. (1) Time aggregation: results are materially unchanged at monthly frequency. (2) Time fixed-effects: switching from month FE to year FE or to no FE (replacing FE with macroeconomic controls including VIX, business confidence, money market premium, 5–2 year yield spread, debt-to-GDP, and the ESMA sovereign bond liquidity index) does not change the sign or significance of the demand and scarcity coefficients. (3) Outliers: winsorizing or truncating at the 5th and 95th percentile preserves the main results despite removing 10–18 percent of observations. (4) SLF specifications: orthogonalizing SLF volumes against Holding, normalizing by total outstanding rather than free float, and lagging up to four periods do not materially change results. (5) Inflation-linked bonds: including inflation-linked bonds (which are less liquid than nominal bonds) amplifies both effects as expected. (6) The paper also checks that the threshold of 40 percent is not driven by threshold choice: results at alternative thresholds (both lower and higher) are consistent in direction.

Q7. What is the broader implication for QE program design?

The results imply that QE programs face a liquidity-yield tradeoff: large-scale asset purchases that achieve meaningful yield compression must reach holding concentrations that materially impair government bond market liquidity, and this impairment is nonlinear and accelerates once concentration exceeds approximately 40 percent of outstanding per bond. For central banks designing future purchase programs, the threshold suggests a natural limit on per-bond concentration, consistent with the ECB’s 33 percent issuer limit for its own purchase programs. The paper also highlights the role of complementary facilities: the SLF partially offsets the scarcity effect on transaction costs, suggesting that security lending programs are a useful adjunct to large-scale asset purchases. The finding that the scarcity effect persists as long as holdings are maintained — rather than reverting when purchases stop — implies that balance sheet normalization (quantitative tightening) may be needed to restore liquidity, not merely a pause in purchases.

Key concepts

demand effect: the temporary improvement in government bond market liquidity on the day of a Riksbank outright purchase, reflecting the positive price impact of incremental buyer demand; positive and significant for four of five liquidity measures, but transitory (does not persist to the following week).

scarcity effect (holding effect): the persistent deterioration in government bond market liquidity caused by the accumulated stock of bonds held by the Riksbank, which reduces free-float supply available to market participants; negative and significant for all five measures, five times larger than the demand effect at average holding levels, and nonlinear — concentrated and amplified when holding share exceeds 40 percent of outstanding.

Yield Impact (YI): a transaction-cost measure of tightness defined as the price change per trade divided by time to maturity; higher YI indicates lower transaction costs per unit of duration; the paper’s primary measure for quantifying the demand and scarcity effects.

Market Efficiency Coefficient (MEC): a resilience measure comparing return variance over long and short horizons; a ratio near one signals efficient absorption of order flow; the measure for which the demand effect is not positive and significant in the baseline, suggesting QE purchases may temporarily disrupt price efficiency rather than improve it.

Securities Lending Facility (SLF): the Swedish Debt Management Office’s bond-lending program that lends government bonds to market makers against collateral; partially offsets the scarcity effect on transaction costs (YI, VAIV) but not on volume-based measures (TURN, TR), and its activity accelerates when Riksbank holdings exceed 40 percent.

free-float supply: the quantity of a government bond available for trading in the secondary market after subtracting the central bank’s holdings; the mechanism through which the scarcity effect operates — lower free-float reduces order book depth and increases transaction costs.