Drivers of Liquidity: A Dealer’s 

Perspective

Jon Kinol

Head of Global Interest Rates

Credit Suisse Securities
2

I. Definition of Liquidity and its Importance

II. Characteristics of Markets where there is a High Degree of Liquidity 

Provided by Market Makers

III. Market Making in the New Capital and Regulatory Environment

IV. Conclusion
Definition of Liquidity

Liquidity is the ability to transact at a low cost, on demand, without significantly affecting the price of the traded asset

Importance:

Market Liquidity  Funding Liquidity

“Liquidity is like confidence. And, like confidence, liquidity plays a critical role both in establishing the conditions than can lead to a 

financial shock, and in determining whether that shock becomes acute, threatening broader damage to the functioning of financial

and credit markets.”

“What role can policy play in reducing the vulnerability of markets to this type of dynamic?”

-Timothy F Geithner

3
II. Characteristics of markets where there is a high degree 

of liquidity provided by market makers

4
Depth of liquidity tends to be much greater in larger 

markets

5

Source: Credit Suisse, Official Sources, as of May 24, 2013

Government bond market Bid/Offer width

*JGBs for 1bn, 10bn and 25bn Yen, Japan Market Size in US$ equivalent 10mm 100mm 250mm Mkt Size

US 1c 2c 3c 11,416

Japan <1c 1c 2c 9,446

UK 1c 4c 7c 2,203

Germany <1c 3c 5c 1,468

France <1c 4c 12c 1,820

Italy 8c 25c 200c 2,488

Spain 15c 50c 300c 956
Markets with greater volume/turnover tend to have 

tighter bid/offer spreads

6

Source: Credit Suisse, as of May 24, 2013

March 2013 Turnover 

(Volume % of Market)

10y Bid/ Offer 

on 100mm

US 25% 2c

Germany 48% 3c

France 31% 4c

Italy 3% 25c

Spain 7% 50c

*JGBs for 10bn Yen 
Liquid two way markets need a diversified ecosystem of 

market participants

Government Securities Ownership by Investor Type

7

Source: Credit Suisse, Official Sources
Both Issuer behavior and issue characteristics can have 

large impacts on security liquidity

8

Source: Credit Suisse, as of May 17, 2013

Issuer:

 -Few surprises in announcements

 -Strong communication and easily observable policy

Issue:

 -Large issues tend to be more liquid, allow tighter bid/offer

 -Known issuance calendar

Bid/offer widened after surprise 

Bank of Japan announcement of 

large asset purchase program 

0.8

0.9

1

1.1

1.2

1.3

1.4

1.5

1.6

1-Mar-13 15-Mar-13 29-Mar-13 12-Apr-13 26-Apr-13 10-May-13 24-May-13

Bid/Offer (10yr JGB, bps)

April 4 BoJ announcement Size (mm) 25mm 50mm 100mm

FHLMC 1.25 8/19 3,500 1.00bps 1.25bps 1.50bps

FHLMC 1.25 10/19 6,000 1.00bps 1.00bps 1.25bps

Size (mm) 25mm

DBR 6.00 6/16 3,750 25c

DBR 4.00 7/16 23,000 7c

Bonds w/similar characteristics, different sizes

Bid/Offer width
Deep funding markets provide dealers the confidence to show 

two way markets, allowing participants to finance positions or 

borrow securities

9

Source: Credit Suisse, Official Sources, as of May 24, 2013

*Bid/Offer on 100mm US or Euro Bid/ Offer (bps)

Repo as % of Sovereign 

Bond Market Repo Haircut

US 2c 24% 1.0%

UK 4c 22% 1.0%

Germany 3c 42% 1.0%

France 4c 22% 1.0%

Spain 50c 16% 5.0%

Italy 25c 12% 4.5%
The more alternatives for hedging and managing risk, the 

greater the comfort in providing liquidity and holding 

positions on the balance sheet

10

Source: Credit Suisse, as of June 11, 2013

Bid/Offer Width for TIPS, Treasuries and Their Hedges

Options on above also provide risk management tools

10mm 100mm 250mm

US TIPS 0.50bps 1.25bps 2.25bps

Inflation Swaps 0.80bps 2.25bps 3.50bps

US Treasuries 0.14bps 0.30bps 0.40bps

Vanilla Swaps 0.25bps 0.40bps 0.50bps

Treasury Futures 0.10bps 0.16bps 0.24bps

Eurodollar Futures 0.06bps 0.06bps 0.13bps

UST Options 0.65bps 0.65bps 0.97bps

Swaptions .75bps 1.5bps 2.5bps
The correlation breakdown between bunds and other 

European bonds led to new instruments being created. 

11

Source: Credit Suisse, the BLOOMBERG PROFESSIONALTM service

0

50,000

100,000

150,000

200,000

250,000

700,000

750,000

800,000

850,000

900,000

950,000

1,000,000

1,050,000

1,100,000

1,150,000

Sep-09 Mar-10 Sep-10 Mar-11 Sep-11 Mar-12 Sep-12 Mar-13

Bund

OAT (rhs)

BTP (rhs)

700,000

900,000

1,100,000

1,300,000

1,500,000

1,700,000

-1

-0.8

-0.6

-0.4

-0.2

0

0.2

0.4

0.6

0.8

1

Jan-06 Jul-07 Jan-09 Jul-10 Jan-12

Correlation of daily Yield Changes in 10y Bunds and BTPs

Bund Future OI (rhs)

Open Interest
12

Source: Credit Suisse, Trade Web

0

20

40

60

80

100

120

140

160

0

0.5

1

1.5

2

2.5

Mar-11 Jun-11 Sep-11 Dec-11 Mar-12 Jun-12 Sep-12 Dec-12

Best Bid/Ask (cents) 10y UST

Avg Size (MM, rhs)

Bid/offer for BTPs have tightened as open interest in hedging instruments 

grows

0

20

40

60

80

100

120

0

20

40

60

80

100

120

140

Mar-11 Jun-11 Sep-11 Dec-11 Mar-12 Jun-12 Sep-12 Dec-12

Best Bid/Ask BTPS 3.75 Mar 2021

(cents)

Avg Size (MM,

rhs)

10y Italian Future

OI (normalized)

Treasury bid/offer spreads have remained stable, 

whereas instruments with less liquid hedges tend to 

be more volatile, such as BTPs
IV. Market Making in the New Capital and Regulatory 

Environment

13
The capital cost of market making in sovereign debt 

has increased significantly post crisis

14

Approximate Equity Capital required to own $1 billion position, assumes single A non-Bank Financial counterparty, bonds 

financed by repo, for one way trade without the benefit of margin or portfolio netting.

Source: Credit Suisse

Basel I Basel II Additions: 

-RWA (Internal Ratings Based/Standardized)

Basel II Basel III Additions: 

-RWA Calcs using Value at Risk (VaR)

-Incremental Risk Capital (IRC) charge

-Increased Capital Requirements (8% 15%)

-Credit Valuation Adjustment (CVA)

-Counterparty Credit Risk (CCR) (US$ millions) Pre-Crisis

Post-Crisis 

(Basel II/ II.5)

New World (Basel 

III/ Dodd-Frank)

US Treasury/Bund/JGB $0.0 $1.6 $9.0

US Agencies $16.0 $16.0 $32.2

IBRD $0.0 $4.0 $9.0

CADES $0.0 $4.0 $9.0

Italian Gov't Bond $0.0 $16.0 $78.7

Spanish Gov't Bond $0.0 $40.0 $78.7

10yr US$ swap (uncleared) $0.20 $0.40 $0.60

10yr US$ swap (cleared) N/A $0.03 $0.10

TY Futures $0.00 $0.03 $0.10
A Financial Transaction Tax could have significant 

impacts on liquidity for all market participants as 

dealers will pass along FTT costs

Source: Credit Suisse, as of June 11, 2013, Oliver Wyman

• Many bid/offer spread could widen 3x to 7x and as much as 18x for 

the most liquid instruments with the tightest bid/offer spreads (FX 

market estimate)

• Financial Transaction Taxes will also have significant impacts on 

financing markets

Bid/ Offer Transaction Tax % Increase

HY Bond (5y, 1pt) 21.2bps 10bps 147%

IG Bond (5y, 5bps) 5.0bps 10bps 300%

France (5y, 5c) 1.1bps 10bps 1009%

Repo (O/N, 2bps) 2.0bps 10bps 600%
The adoption of Dodd-Frank and Prudential Regulation 

may impact the funding market

16

Source: TBAC

This may have material negative implications for sovereign liquidity in 

stressed situations.

New margin and capital rules will increase demand for high quality assets, 

which could become acute during periods of stress reducing government 

bond market liquidity and creating problems in Repo markets

Incremental HQC 

Demand1

1. Prudential Regulation 2. Market Regulation 

(Derivative Clearing)

3. Market Regulation 

(Bilateral Margin)

4. Economic 

Environment / 

Uncertainty

=

+ + +

Increased prudential liquidity 

requirements

Increased IM requirements for 

cleared derivatives

Increased IM requirements for 

non-cleared derivatives

Cyclical HQC investment 

demand (FTQ flows)

$1.0-2.5tt • $0.8-2.0tt (normal)

• $1.8-4.6tt (stressed)

• $0.8-1.2tt (normal)

• $1.8-4.1tt (stressed) Varies (multi-$trillions)

 Total “phased-in” potential incremental HQC demand (normal market conditions): $2.6-5.7tt

 Total “phased-in” potential incremental HQC demand (stressed market conditions): $4.6-11.2tt + FTQ 

Flows

Incremental drivers of HQC demand include the following:
When collateral is horded, repo market fails can 

increase dramatically.

17

Source: NYFRB, Credit Suisse

In periods of stress, the 

depth and resilience of 

funding markets is critical to 

liquidity.

0

2

4

6

8

10

12

Jan-10 Jul-10 Jan-11 Jul-11 Jan-12 Jul-12 Jan-13

Italian 10yr Bid/Offer (bps)

Spanish 10yr Bid/Offer (bps)
Dodd-Frank: Volcker Rule

18

Source: Credit Suisse, Federal Reserve, Oliver Wyman

• The Volcker Rule may negate the benefits of alternative hedges.

• A large numbers of issues inherently fragments liquidity, Volcker could 

increase this fragmentation by reducing ability to inventory positions

-80,000

-60,000

-40,000

-20,000

0

20,000

40,000

1/07 6/07 11/07 4/08 9/08 2/09 7/09 12/09 5/10 10/10 3/11 8/11 1/12 6/12 11/12 4/13

Dealer's Net Longs ($mm)

6-11 year Treasuries (cash)

TY (inverted)
Other Prudential Regulations that Impact Liquidity:

19

Source: BIS April 2013 Basel 3 Progress Report, Official Sources

Balkanization of Regulatory and Capital Environment

Multiple regulatory regimes globally, some banks operate under home capital 

rules that are much stricter than the peers with which they compete

Basel III Leverage Ratio

Potential Wholesale Funding Changes

SEFS for Swap Trading

Trade Reporting for Swaps

Country Basel Rules Regulations (both implimented and pending)

USA 1, 2 & 2.5 Swap Clearing/Margining/SEFs, Volcker, CFPB, FSOC, Bi-laterial Margining

Switzerland 3 OTC derivatives rules pending, Bi-laterial Margining

EU 2.5 OTC Clearing/Margining Short Sale Regulation, Derivatives Standardization, FTT

Japan 3 Nearly all rules implemented except SIFI capital buffers, Bi-laterial Margining
V. Conclusion

20
Conclusions

21

Source: Credit Suisse, Federal Reserve, Oliver Wyman

• The greater the texture of a market the greater the liquidity.

• The mix of new prudential and market regulatory requirements could 

incent behavior that may be detrimental to liquidity

• In stressed periods the markets are more susceptible to the pro-cyclical 

nature of liquidity. This can cause increased reliance on public 

institutions for liquidity, requiring faster and deeper policy response.
Liquidity of various government markets

22

Source: Credit Suisse

0

20

40

60

80

100

120

140

DBR 2.500 01/04/2021

FRTR 2.500 10/25/2020

BTPS 3.750 03/01/2021

UST 10y

Cents