There are competing arguments about the likely effects of Sovereign Bond-Backed Securitization (SBBS) on the liquidity of sovereign bond markets. By analyzing hedging and diversification opportunities, this paper shows that positive liquidity spillovers would dominate or at least constrain the extent of any negative effects. This relies on dealers using Sovereign Bond-Backed Securities as instruments to hedge inventory risk and it assumes that they diversify their activities widely across euro area sovereign markets. Through a simple arbitrage relation, the existence of low-cost hedging and diversification opportunities limits the divergence of bid-ask spreads between national and SBBS markets. This is demonstrated using estimated SBBS yields.
One important policy implication of analysis by researchers from the European Systemic Risk Board (ESRB) is that primary dealers will seek to have a presence in more markets. This follows from the fact that much of the risk at local level cannot be hedged using SBBS but is easily diversified. Dealers with, on average, a more diversified portfolio will face lower risks and will be able to out-price non-diversified dealers. Most markets in Europe have a majority of dealers with diversified market making activities but some additional diversification is likely to occur. There is obviously a trade-off here between specialization, which helps to make price discovery more efficient, and diversification for risk management purposes.