Decoding OTC Government Bond Market Liquidity: An ABM Model for Market Dynamics

TL;DR

This paper presents an agent-based model to analyze liquidity and stability in OTC government bond markets, highlighting how agent diversity and market-making costs influence market dynamics.

Contribution

It introduces a bespoke ABM simulating market-maker interactions in OTC government bond markets, providing new insights into micro-structural effects on market stability.

Findings

Greater agent diversity improves liquidity

Reducing market-making costs enhances stability

Micro-structural factors significantly impact macro market outcomes

Abstract

The over-the-counter (OTC) government bond markets are characterised by their bilateral trading structures, which pose unique challenges to understanding and ensuring market stability and liquidity. In this paper, we develop a bespoke ABM that simulates market-maker interactions within a stylised government bond market. The model focuses on the dynamics of liquidity and stability in the secondary trading of government bonds, particularly in concentrated markets like those found in Australia and the UK. Through this simulation, we test key hypotheses around improving market stability, focusing on the effects of agent diversity, business costs, and client base size. We demonstrate that greater agent diversity enhances market liquidity and that reducing the costs of market-making can improve overall market stability. The model offers insights into computational finance by simulating trading without price transparency, highlighting how micro-structural elements can affect macro-level market outcomes. This research contributes to the evolving field of computational finance by employing computational intelligence techniques to better understand the fundamental mechanics of government bond markets, providing actionable insights for both academics and practitioners.