The Relationship between Market Depth and Liquidity Fragility in the Treasury Market

Andrew Meldrum and Oleg Sokolinskiy

No 2025-014, Finance and Economics Discussion Series from Board of Governors of the Federal Reserve System (U.S.)

Abstract: Analysis of market liquidity often focuses on measures of the current cost of trading. However, investors and policy-makers also care about what would happen to liquidity in the event of an adverse shock. If liquidity were to deteriorate rapidly at times when investors were seeking to rebalance portfolios, this could amplify the effects of shocks to the financial system even if liquidity is high most of the time. We examine the potential for such fragility of liquidity in the Treasury market. We show that a reduction in the availability of resting orders to trade ("market depth") increases liquidity fragility, likely because lower depth increases the dependence of low trading costs on prompt replenishment of resting orders. Our results apply to all major benchmark Treasury securities individually, which enables us to establish analogous conclusions for market-wide liquidity fragility.

Keywords: Liquidity; Fragility; Treasury market; Price impact; Volatility; Market depth; Hidden Markov model (search for similar items in EconPapers)
JEL-codes: C51 C58 G01 G10 G12 (search for similar items in EconPapers)
Pages: 43 p.
Date: 2025-02-21
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Persistent link: https://EconPapers.repec.org/RePEc:fip:fedgfe:2025-14

DOI: 10.17016/FEDS.2025.014

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