Fostering Core Government Bond Market Resilience
IMF Blog, May 21, 2025
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- Authors: Tobias Adrian, Kleopatra Nikolaou, Jason Wu
- Published: May 21, 2025
Importance of government bond market functioning
- Government bonds serve as the bedrock of capital markets, acting as benchmarks whose yields influence corporate bonds, mortgages, and derivatives.
- Many financial transactions use government securities as collateral for hedging and pricing.
- Bond yields reflect economic prospects, risks, and market functioning; yields can rise for fundamental reasons (improved economic outlook or higher inflation expectations) or because investors demand additional compensation for uncertain interest rates (term premium).
- If higher risk premia are aggravated by dysfunctions in government bond markets, yields can rise excessively relative to fundamentals, potentially undermining efficient capital allocation.
Recent performance and identified vulnerabilities
- Government bond market functioning demonstrated resilience despite very high volatility; continued stability is essential for the financial system (as described in the latest Global Financial Stability Report).
- Markets recently adjusted sharply to an abrupt re-assessment of the global macroeconomic environment and elevated trade policy uncertainty.
- Liquidity is multi-faceted and measured by transaction-level metrics (bid-ask spreads, trading volumes, market depth) and model-based methods; different metrics can convey different signals.
- Example: bid-ask spreads suggest mild pressure on liquidity in the past few years, while yield curve fitting errors have increased for some of the world’s largest bond markets, suggesting reduced liquidity.
- Some episodes show that core bond market liquidity can evaporate quickly in times of stress, and day-to-day liquidity may deteriorate.
Dealer intermediation dynamics and constraints
- Primary dealers bid in auctions on behalf of clients, support secondary-market liquidity, and are the main intermediaries of major government bond markets; most are subsidiaries of large banks and have sizable balance sheets to warehouse inventory and provide financing.
- In volatile markets, dealers face rising value-at-risk and other risk metrics, challenging their ability to intermediate; increased dealer perceptions of risk can reduce market-making and amplify illiquidity.
- Major bank-dealers have expanded government bond holdings, but not in proportion to outstanding bond growth:
- In the United Kingdom, gilts grew twice as fast as UK bank-dealer balance sheets (as shown in the October 2023 Global Financial Stability Report).
- The stock of US Treasury securities grew nearly fourfold in the 15 years through 2023, while US bank-dealer balance sheets expanded by just 1.5 times.
- US Treasury securities account for almost 70 percent of primary dealers’ securities inventories, the highest share in over a decade.
- About three-quarters of primary dealers’ securities financing is also collateralized by Treasuries.
- Dealers’ internal limits on concentrated holdings could curtail intermediation, especially in times of stress.
Role and implications of nonbank financial institutions (NBFIs)
- Some NBFIs (mutual funds, exchange-traded funds, insurance companies, and pension funds) are key buyers; others (principal trading firms and some hedge funds) have become important market-makers in specific segments.
- The shift toward electronic trading has helped principal trading firms gain market share.
- NBFI market-makers can reduce reliance on bank-dealers, increase intermediaries, and improve liquidity, but they may quickly curb activities during market stress due to weaker mandates to support markets.
- Past examples: the 2014 Treasury market flash rally and the 2020 global dash-for-cash at the onset of the pandemic.
- The increasing presence of NBFIs makes market resilience more uncertain and opaque because they tend to be less regulated and subject to fewer data reporting requirements.
Policy progress, gaps, and recommendations
- Central bank interventions introduced in recent years to stabilize bond markets include asset purchases and lending facilities—primarily through repurchase agreements (repos).
- These tools support bond market functioning but are no substitute for structural resilience.
- Central clearing mitigates counterparty and default risks, improves transparency, and allows intermediaries to offset long and short positions against a central counterparty, boosting balance sheet efficiency and capacity.
- Adoption varies by country:
- In Japan, significant shares of both cash and repo transactions are centrally cleared.
- The United States only recently introduced a mandate.
- In Germany and the United Kingdom, some repo trades are centrally cleared but cash transactions aren’t.
- While central clearing does not guarantee resilience, international consensus on its benefits is growing.
- Timely and comprehensive market data are crucial; recent volatility revealed data gaps and reporting lags that obscure real-time drivers of market functioning (e.g., selling pressures).
- Progress on data coverage has not been uniform across countries; important gaps remain for key participants such as dealers and hedge funds.
- Policymakers should:
- Broaden central clearing.
- Monitor market-making activities, including by nonbank financial institutions.
- Obtain better information on NBFIs’ financial soundness, operational resilience (including cyber resilience), and likely behavior under stress.
- Dealers should:
- Continue to build capital and liquidity during stable times to be able to serve markets under stress.
- Complete internationally agreed regulatory reforms for banks to support dealer resilience.
Source: Fostering Core Government Bond Market Resilience, May 21, 2025.
Content in this bundle
- US Treasury Market Functioning from the GFC to the Pandemic