The Risks of Quantitative Easing to Market Liquidity: the ECB's Public Sector Purchase Programme and the German Government Debt Securities Market

The aim of this research is to discuss the risks that quantitative easing (QE) may pose to market liquidity. The objective is to assess if the magnitude or the design of the ECB's public sector purchase programme (PSPP) undermines the market liquidity of purchased securities. This research focuses on the German government debt securities market. Market participants have warned that the effective supply of German government debt securities is low in relation to PSPP purchases, which could cause scarcity and undermine market liquidity. The PSPP could weaken the market liquidity of purchased securities by reducing their effective market supply. The scarcity could also cause shortage of collateral in the repo market, which would increase hedging costs and contribute to higher market making costs. As a result, the PSPP could discourage market making in the purchased securities, which would undermine liquidity resilience. In addition, a particularly low level of market liquidity could suppress the price discovery mechanism, which would diminish the effectiveness of QE's portfolio balance channel. Transaction level data on PSPP purchases is not publicly available, which rules out a detailed analysis on the PSPP’s stock and flow effects. Instead, this research utilizes an event study approach to measure the impact of the EAPP announcement in January 2015 on the market liquidity of PSPP-eligible securities. The event study is based on the assumption that the quoted bid-ask spreads partly reflect market makers' expectations of market making costs. This research also determines which securities were most and least likely purchased under the PSPP. The price discovery and liquidity resilience of those securities is then measured from March 2014 until March 2016. This research utilizes Reuters Datastream’s data on prices and bid-ask quotes. The results suggest that the PSPP did not undermine the market liquidity of purchased securities to a significant degree. Indeed, price discovery and liquidity resilience did not deteriorate among those securities that were most likely purchased under the PSPP. However, after the EAPP announcement, the relative bid-ask spreads widened among those PSPP-eligible securities with remaining maturities of over ten years