Central Bank Liquidity Facilities and Market Making
In March 2020, the spread of COVID-19 led to turmoil in financial markets around the world. Behind this turmoil was the need by large asset managers to convert assets to cash to meet redemptions and margin calls. As a result, large volumes of fixed-income securities were sold to investment dealers who had limited ability or risk tolerance to purchase them. Many previously liquid markets either became illiquid or seized altogether. To calm markets, central banks, including the Bank of Canada, intervened on a historically large scale and scope using several measures, including asset purchase programs.
We create a theoretical model of central bank asset purchases. This model enhances our understanding of how asset purchases ease pressures on investment dealers. Our model shows that asset purchase programs restore market liquidity by freeing up space on the balance sheets of investment dealers. This makes it possible for assets to be sold to dealers more easily, thereby allowing investors to raise cash at lower cost.
Many investors who rely on their ability to sell assets in a crisis are non-bank financial intermediaries (NBFIs), such as asset managers, mutual funds and hedge funds. NBFIs channel savings and investments, including fixed-income securities, outside of the traditional banking sector. Other work has shown that the capacity of investment dealers has not kept pace with growth in the NBFI sector, and this has increased the volume of bonds dealers are asked to hold on their balance sheets. Because of these greater demands, crisis support from central banks, the topic of our work, will likely continue to be important.