The public sector issues government bonds to finance its expenditures. A stable government bond market, then, supports the state in the fulfilment of its duties. Government bonds are usually characterised by low liquidity risk. This risk describes how quickly and at what prices large holdings of securities can be traded. The low liquidity risk is a main factor that makes government bonds a central component of modern financial markets and renders them essential for financial stability.

The determinants of liquidity on the German and Italian government bond markets were explored in a joint project undertaken by the Bundesbank and the Banca d’Italia for this article.

After the Eurosystem, investors from China are the largest holders of German government bonds, followed by investors from the United States and the United Kingdom. Additionally, euro area-based non-bank financial intermediaries (NBFIs), particularly investment funds, hold large amounts of German government bonds. Thus the holder structure is not bank-centric, and the level of involvement of foreign investors and NBFIs is significant for the price discovery mechanism in the German government bond market. While the high share of foreign investors allows for more diversified holdings and therefore creates additional demand, international contagion may temporarily lead to higher market price volatility. The majority of Italian government bonds, on the other hand, are held by domestic banks, insurers and households. While this large domestic share creates stability in the investor base, it also implies a higher degree of interconnectedness within the economy.

German government bonds are mostly traded over-the-counter (OTC) and bilaterally on the secondary market. By contrast, trading in Italy mainly occurs via a regulated electronic trading system, and most transactions are cleared through a central counterparty. Both trading mechanisms have their own advantages and disadvantages, which relate to efficiency, transparency, trading costs and availability of information. Such mechanisms can influence market liquidity conditions.

Government bonds are also frequently used in repurchase agreements (repos). Repos can be used to bridge short-term liquidity shortages and to obtain specific securities. Shortages, as seen in recent years mainly with German government bonds, manifest through increased costs of borrowing such securities in the repo market. The type and investment strategy of market participants can influence the scarcity of securities in the repo market.

The analyses conducted in the joint project by the Bundesbank and the Banca d’Italia show that participants in the German and Italian government bond markets differ significantly, and that this may have divergent impacts on market dynamics. To support the resilience of government bond markets, it is crucial to better understand the investment strategies and reaction behaviours of participants. This, in turn, requires the use of granular data, especially data which pertain to the securities portfolios of foreign investors and are not always available.

A liquid government bond market is essential for a functioning financial system. Government bonds from many advanced economies are considered by investors and regulatory authorities to be high-quality liquid assets (HQLA). Accordingly, these securities have a wide range of uses. They serve as collateral in various markets, particularly in the repo market, which predominantly handles government bonds. Central counterparties (CCPs) also accept government bonds as collateral (initial margin requirement). In order for government bonds to be used as collateral in various ways, it is crucial that this collateral can be sold quickly and easily in the market.

The liquidity of government bonds is also important because it supports their function as a safe investment in investors’ portfolios. In times of higher market volatility, they are typically stable in value, particularly those issued by advanced economies. This makes government bonds a popular choice when it comes to diversifying investment portfolios. They sometimes serve as insurance against unexpected negative events. 1 However, for government bonds to be considered a safe investment, it must be possible to sell them quickly and at a price justified by fundamentals even during times of economic uncertainty, or to use them in the repo market for short-term refinancing.

For investors, securities therefore have a higher value when they know they can sell them quickly, in large volumes, and without significant price discounts even in economically uncertain times, or temporarily exchange them for cash in the repo market. Confidence in the high liquidity of government bonds is often particularly strong, meaning that investors are willing to accept lower yields. This allows issuing states to obtain financing at favourable conditions, contributing to the stability of public finances.

The liquidity of government bond markets heavily depends on how they are organised and the market participants involved. Both factors may respectively influence vulnerabilities in the government bond market as well as financial stability. This became evident during the turbulence in the US and other international government bond markets in March 2020, when the reactions of different market participants impaired the liquidity of the government bond market. 2

The German and Italian government bond markets play a central role in their respective national financial systems, but they differ in their structure and in the way in which they function. In both markets, bonds are issued through auctions and traded on well-developed secondary markets. They offer a variety of bond types with different maturities of up to 30 years for German and 50 years for Italian government bonds. In both countries, the respective Ministry of Finance makes the strategic decision on the issuance of government bonds. In Germany, the Federal Republic of Germany – Finance Agency plays a central role in operational business. It handles debt management, borrowing, and cash management on behalf of the Federal Republic of Germany. In Italy, this role is predominantly assumed by the Ministry of Economy and Finance.

At the end of 2023, the Federal Republic of Germany had an outstanding nominal volume of Federal securities worth €1.8 trillion across various maturities. 3 The outstanding volume of Italian central government securities was €2.4 trillion at the same point in time. 4 These government bonds can be traded on the cash market.

A significant portion of German government bonds are held by foreign investors, whereas Italian government bonds are predominantly held by domestic investors. 5 The largest holder of both countries' issued bonds is the Eurosystem. Since the Eurosystem acts market-neutrally in monetary policy purchases, central bank holdings are not included in this analysis. At the end of 2023, foreign investors held about 77 % of German government bonds, with around 50 % being held outside the euro area (see Chart 6.2.1). Investors from China were the largest group of holders, followed by investors from the United States and the United Kingdom. In addition, euro area NBFIs, in particular investment funds, held large shares of German government bonds. 6 By contrast, around 60 % of Italian government bonds were held by Italian investors at the same point in time. The largest share was held by domestic banks, followed by insurance companies and households. 7

On the secondary market, German government bonds are mostly traded over-the-counter and bilaterally, whilst Italian government bonds are traded via a regulated electronic trading system that includes a settlement and clearing system. In Italy, trading predominantly occurs between dealers on the regulated trading platform MTS Italy, with transactions being cleared through a CCP. In other words, the trading mechanism in Italy is centralised, while that of Germany is decentralised. In Germany, a large portion of transactions between dealers and their end investors take place bilaterally. In 2023, the average daily trading volume between dealers and their end investors came to around €18 billion for German government bonds, compared with approximately €13 billion for Italian government bonds. 8 The non-bank sector, particularly asset managers and hedge funds, is strongly represented in both the German and Italian markets and also plays an important role in government bond trading.

The repo market is a part of the secured money market and serves the purpose of short-term procurement of funds and securities. In a repo transaction, a security is sold with the simultaneous agreement to repurchase the security at a later date at a predetermined price. This allows repos to be used to obtain short-term funds without permanently parting with a security. Additionally, repos can be used to obtain specific securities for a certain period. 9 Government bonds are by far the most commonly used securities in the repo market due to their typically low liquidity risk and credit risk, which reduces the risk of incurring losses in the event of a default on the part of the cash debtor. 10 High liquidity in the repo market enables smooth access to funds and securities. Dealer banks, in particular, use the repo market to obtain funds or in-demand securities. This creates confidence in holding government bonds and thus contributes to liquidity in the secondary market. Repo markets are therefore considered a central component of the financial system. Disruptions in the repo market can spread throughout the entire economy and pose a risk to financial stability. 11

Repos backed by German and Italian government bonds are cleared in a similar manner, but differ in terms of total volume and counterparties. The daily transaction volume of repos using German government bonds increased from around €140 billion in August 2021 to about €180 billion in August 2024. At the same time, the transaction volume of repos with Italian government bonds grew from around €160 billion to about €280 billion. If we look at the repo market transaction volume as a whole, about 65 % of the German and 70 % of the Italian volume is cleared centrally. Both markets are dealer-based, meaning a dealer bank is involved in most transactions. Based on transaction volumes, NBFIs have a market share of about 15 % in German government bonds in the repo market, of which a large portion can be attributed to hedge funds. Looking at the countries of the final counterparties, most repos secured by Italian government bonds are traded between counterparties within the euro area, particularly counterparties from Germany (see Chart 6.3.1). 12 By contrast, repos with German government bonds often involve counterparties outside the euro area.

The interest rate for repo transactions is also influenced by the scarcity of the underlying security. Various market participants need to obtain specific securities for different reasons, sometimes at short notice (e.g. to fulfil delivery obligations from futures contracts). 13 Under certain circumstances, this can lead to an increase in demand for specific securities relative to supply, making it more expensive to obtain these securities in the repo market. Through the monetary policy asset purchases carried out in the context of quantitative easing, the Eurosystem acquired a large stock of government bonds, reducing the supply of government bonds available for trading. 14 The limited supply made it more expensive to obtain government bonds through the repo market. This was particularly the case for German government bonds, but was also observed – to a lesser extent – for Italian government bonds (see Chart 6.3.2). 15

As the Eurosystem’s balance sheet is gradually reduced, the stock of government bonds in circulation slowly increases, making more government bonds available to the market. The supply of government bonds in the repo market has been further increased by several measures, including securities lending by central banks and participation in repo markets by public authorities. 16 As a result, almost all repos with German government bonds continue to be traded at interest rates below the Eurosystem’s deposit facility rate, meaning that a premium is paid for these bonds, although the difference from the deposit facility rate has significantly narrowed. This development is also evident for repos with Italian government bonds, where the premium paid to obtain Italian collateral is now less pronounced. Chart 6.3.2 illustrates this development, showing the relative traded transaction volume by the interest rates charged on repo transactions. If these repo rates are significantly below the Eurosystem’s deposit rate, this indicates a relative scarcity of the underlying security. If the repo rates are at or above the deposit rate, the underlying security is not scarce, and the repo transaction is more likely to be used to obtain funds rather than to obtain the underlying security. This observation illustrates how a scarcity of securities may be accompanied by a price increase for short-term securities procurement in the repo market.

The investor base can also influence liquidity in the repo market. An analysis of the Italian repo market by the Banca d’Italia shows that when government bonds are predominantly held by “inelastic investors”, the interest rates on these repos are relatively low, meaning premia are paid for borrowing these bonds. 17 The reason for this is that such investors are probably less likely to lend their bonds in the repo market, making these bonds less readily available. 18 It would seem fitting to gain an understanding of whether and how these inelastic investors could be encouraged to participate more actively in the repo market, since lending scarce government bonds could be profitable for them.

Our study suggests that the liquidity and the stability of the German and Italian government bond markets may depend on a variety of factors. These factors include how each government bond market is organised, how and by which investors transactions are conducted, and the heterogeneity and number of market participants.

Investors typically use OTC bilateral trading for German government bonds, whilst Italian government bonds are traded and settled using electronic trading systems. These trading mechanisms can each come with a range of trade-offs, most likely to be related to efficiency, transparency, trading costs, and availability of information, especially in economically uncertain times. 19

The holder structure of German government bonds exhibits a large share of foreign investors and investment funds. How and to what extent foreign investors and NBFIs are involved is significant for the price discovery and liquidity of government bonds. The high share of foreign investors across countries results in more diversified holdings of German government bonds and therefore creates additional demand, including in the event of changing market conditions. However, this may temporarily increase market price volatility due to the risk of potential international contagion.

By contrast, a large proportion of Italian government bonds are held by domestic investors, among which domestic banks are the largest holder group. This large domestic share leads to greater stability in the investor base, potentially mitigating adverse effects from changes in foreign investors’ behaviour. However, it may also imply a higher degree of interconnectedness within the economy.

The behaviour of market participants can influence the liquidity conditions of government bonds. Given the important role of NBFIs in the holder structure of the German government bond market, it is particularly important to expand our understanding of their investment strategies and reaction behaviour, especially in economically uncertain times. This requires the use of more granular data, although these are not always available.

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