| 12.09.2011 |
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| New Research in the Bank of Israel: The Effect of the 2006 Market Maker Reform on the Liquidity of Local-Currency Unindexed Israeli Government Bonds in the Secondary Market |
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| To view this press release as a WORD file - Click here |
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This study shows that the market makers reform introduced in 2006 by the Ministry of Finance increased the level of activity in the secondary market for local-currency unindexed government bonds. The reform did not however reduce liquidity cost or deepen the market. |
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The study identified two reasons for the partial success of the reform in the area of liquidity: first, the maximum spread in the MTS[1] trading system (the trading platform that is exclusive to the primary dealers) is too high, and second, market makers' activity in the stock exchange does not provide liquidity to the market. |
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Indices of liquidity used in the study to examine the effect of the reform on liquidity now enable market liquidity to be monitored on an ongoing basis, and provide another indication of financial developments in Israel. |
| This research undertaken in the Bank of Israel by Inon Gamrasni of the Bank's Research Department examines the effect of the market makers reform implemented by the Ministry of Finance in 2006 on the liquidity of local-currency unindexed government bonds on the secondary market. The approach adopted was to calculate a wide range of liquidity indices that together enable the development of financial assets to be monitored. The indices are calculated on a basis of intra-day data, and are divided into three groups: the extent of activity, represented by the index of turnover and the index of the frequency of trade; liquidity cost, represented by the index of the bid-ask spread and the index of the cost of a round trip (CRT); and the depth of the market, represented by the index of the price impact, the index of the amount quoted, and index of the size of transaction. The study also estimates the volatility of yields during the trading day. |
| The market makers reform included the launch of a new platform for auctions, the appointment of domestic and foreign primary dealers, and the introduction of a new exclusive system of trading by primary dealers (the MTS system). The main purpose of the reform was to reduce the cost of government borrowing by means of increasing the liquidity in the secondary market, increasing transparency, opening the market, and the entry of nonresidents into the market. |
| The study estimates the impact of the reform, represented in the equations by the volume of trading in the MTS system as the independent variable, on each of the different indices of liquidity. This, after taking into consideration changes in the economic environment that occurred during the sample period, before and after the reform. |
| The findings of the study show that although the reform did increase the extent of activity in the market, it did not succeed in reducing liquidity cost or in deepening the market, so that it cannot be claimed that the level of liquidity improved as a result of the reform. Two reasons are proposed. |
| The first is that the spread set by the Ministry of Finance between the purchase price and the sales price as the minimum spread for each primary dealer in the MTS system is significantly higher than the actual spread in trading in the stock exchange. It is therefore not worthwhile for liquidity consumers in the secondary market to deal with the primary dealers. |
| The second reason proposed is that in most transactions (between 50 percent and 70 percent of the total in the sample period) in which a market maker was one of the sides to a transaction (whether buyer or seller), they were the initiators of the transaction; in other words, they consumed liquidity, and hence did not improve the liquidity level in the market. And this when the role of the market maker is specifically to provide liquidity (so that the share of transactions in which market makers are the initiators should be significantly lower than 50 percent). |
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| [1] The system is operated by the MTS company, which operates several similar systems in other countries in Europe. |
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