Could all to all trading improve liquidity in the Government of Canada bond market

Introduction

Government bond markets are typically considered to be among the most-liquid fixed-income markets. Even so, liquidity conditions in government bond markets can deteriorate sharply when a sudden imbalance occurs between the demand for and supply of liquidity. In fact, in recent extreme episodes of market turmoil like the onset of the COVID-19 crisis in March 2020 and the UK gilt crisis in September 2022, market liquidity deteriorated so much that central banks intervened by buying government bonds to stabilize and restore orderly functioning of these markets.

Some policy-makers, academics and financial market participants believe that one reason market liquidity of government bonds is vulnerable to periods of market turmoil is because the structure of these markets is centred around dealers. In this type of market structure, dealers use their own balance sheets or act as a broker to match offsetting transactions between their different clients. In periods of turmoil, however, client demands for liquidity can surge, and trading can become more one-sided. In other words, many clients trade bonds in the same direction, by, for example, buying government bonds in a flight to safety or selling government bonds in a dash for cash.

Dealers may charge a higher fee to intermediate such trades as compensation for the additional risks that they bear on their own balance sheets when market conditions are volatile.1 In extreme cases, dealers may stop intermediating completely, either due to constraints on their balance sheets or their inability to hedge risks. This could prevent transactions from occurring among clients who would otherwise be willing to transact with one another.

Adopting an all-to-all market structure is one of several proposals for improving the resilience of government bond markets during periods of turmoil (Duffie 2023). In this structure, market participants would be able to transact directly with each other on an electronic trading platform and therefore avoid any limits in dealers' ability to intermediate. An all-to-all structure could also attract new market participants through increased transparency of executable and executed prices on all-to-all trading platforms. This increased transparency could improve the bargaining power of market participants and reduce barriers to entry that may exist in a dealer-intermediated structure. Supporters of all-to-all trading argue that a more diverse set of market participants could improve market liquidity. This is because it could increase the likelihood and amount of bond transactions occurring in opposite directions, even during periods of turmoil. These offsetting transactions could reduce pressures on market liquidity.

To examine these considerations of all-to-all trading, we use granular transaction-level data to assess how much client-to-client trading could be possible in the Government of Canada (GoC) bond market. We find, on average, almost half of the GoC bond transactions of dealers' clients could potentially be offset with those of other clients over the trading day. This share is stable over time, including during the COVID-19 crisis in March 2020. This demonstrates that clients were indeed transacting in the opposite direction of other clients' transactions in a period of market turmoil. For GoC bond futures-instruments that are like GoC bonds but trade on an all-to-all platform-we find that almost all clients' transactions can be offset by those of other clients and that this high offsetting share is also stable.

So would all-to-all trading support liquidity in the GoC bond market? The answer remains unclear. On the one hand, our results shed some light on the potential for clients' transactions to offset each other. On the other hand, our methodology overlooks important considerations for the sake of simplicity. For instance, we do not account for differences in the prices when offsetting client transactions or for the influence that client-dealer relationships may have on trading behaviours. These considerations make it challenging to understand whether our estimated extent of client offsetting would take place if GoC bonds were traded entirely on an all-to-all platform. In addition, several other aspects of all-to-all trading merit further investigation.

All-to-all trading presents a range of risks and considerations

While all-to-all trading may bring benefits, it presents a range of risks and considerations. Critics argue that the potential for matching transactions across different participants could be minimal in periods of market turmoil. They argue that even new entrants could have demands for liquidity that lead them to transact government bonds in the same direction as other clients, amplifying one-sided trading rather than promoting matching. Some critics also argue that new entrants and existing clients would have fewer incentives to maintain intermediation services in periods of turmoil. They cite the lower importance on relationships with clients on an all-to-all platform compared with a dealer-intermediated structure as the reason for the potential reduction in intermediation services.

Other considerations that require further analysis include:

• the impact of greater price transparency on an all-to-all platform can affect the behaviour of market participants
• the impacts to settlement and clearing risks as clients' transactions are executed on an all-to-all platform
• the potential negative impacts to other services provided by dealers, such as access to primary bond markets
• the implications for markets, such as repurchase (repo) or derivatives markets, that trade in conjunction with GoC bonds
• the potential reduction of capital that dealers allocate to their intermediation businesses

Almost half of transactions could potentially be offset on any given trading day

Using data from October 2019 to November 2023 on GoC bond transactions from the Market Trade Reporting System, we calculate the share of transactions of clients of dealers that could have potentially been offset by transactions with other clients within a trading day, following Chaboud et al. (2022).2 In other words, for each purchase of a specific bond that a client makes, what share of the amount bought was sold by other clients on the same trading day and vice versa. The methodology allows buys and sells to offset each other despite potential differences in the prices of trades or the exact times within the day that trade trades occurred.3 It also does not match exact trade amounts; instead, it looks at total buys and sells for a specific bond. Despite these limitations, our methodology helps establish estimates of how many client transactions in a trading day could potentially be matched.

Chart 1 reports the average daily amount of GoC bond transactions that can be offset by clients as a share of the amount of transactions offset plus the residual amount that is not offset. Across all types of GoC bonds, 49% of client transactions could be offset on an average trading day. Across bond tenors, the offsetting shares range from 57% to 65% for benchmark bonds and from 23% to 46% for non-benchmark bonds.

The higher offsetting shares for benchmark bonds is likely due to their greater liquidity, which leads to higher turnover of trading volume compared with that of non-benchmark bonds (Gungor and Yang 2017). The relatively lower offsetting share for non-benchmark bonds suggests that dealers play an important role in using their balance sheets to intermediate these less-liquid bonds. Overall, high offsetting transactions among clients promote two-sided markets. This can help dealers more easily find the bonds or cash they need to fulfill their clients' transactions, which could promote market liquidity (Sandhu and Vala 2023a).

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