Funding Constraints and Market Liquidity in the European Treasury Bond Market

Theoretical studies show that shocks to funding constraints should affect and be affected by market liquidity. However, little is known about the empirical magnitude of such responses because of the intrinsic endogeneity of liquidity shocks. This paper adopts an identifcation technique based on the heteroskedasticity of liquidity proxies to infer the reaction of one measure to shocks affecting the other. Using data for the European Treasury bond market, we find funding liquidity shocks affect bond market liquidity more than its reversed counterpart. This effect is stronger for short-term bonds and for bonds used as collaterals in repo transactions.