**6. Conclusions**

This paper assesses how the existence of sovereign bond-backed securities affects dealer intermediation in individual euro area sovereigns. An arbitrage relation is used to demonstrate that the hedging of inventory risks with SBBS eliminates most systematic inventory holding risks. Furthermore, it is asserted that diversification of intermediation activities across countries, in combination with hedging, then produces further reductions in exposures. These assertions are tested using estimated SBBS yields and the findings are generally positive. Even if one assumes a similar capital exposure under hedging and not-hedging, there is still a marked reduction in risks through hedging and diversification. Overall, assuming regulation does not excessively penalise netting of inventory positions in different sovereign and SBBS, and if SBBS are sufficiently liquid, a significant improvement in trading costs across all European sovereign debt markets seems plausible.

Risk reduction through diversification (after hedging) was assessed using equal-weighted and size-weighted portfolios of long positions in the bonds from the underlying sovereigns. This could be misleading since it is quite likely that actual inventories would be some mixture of long and short positions. This simplification will tend to underestimate the risk-reducing benefits of diversification. Since holding period investment returns in sovereign markets are predominantly positively correlated (except when there is a pronounced flight to safety), a combination of long and short positions will lead to more netting of valuation changes and this will most likely reduce risk relative to what is reported for the present analysis. This represents a fruitful avenue for future investigation.

A further useful extension of the above analysis would be to assess whether there are liquidity spillovers among the SBBS tranches. In fact, these spillovers have already been identified in terms of the incremental hedge effectiveness that was achieved when portfolios that included all three SBBS were analysed. However, in the developmental phase of the SBBS market, liquidity spillovers between the SBBS themselves could be important for liquidity of the junior tranche which will have the smallest issuance volume among the three. It seems likely that the senior SBBS would be helpful to dealers in providing quotes in the mezzanine market (purely via hedging). A spillover from the mezzanine to the junior is then possible. Preliminary analysis of the correlations between the tranches under most circumstances suggests that these hedging avenues for liquidity spillovers would be positive. Of course, in crisis circumstances, flight to safety could disrupt correlations more dramatically than can be anticipated by dealers and this would undermine the reliability of risk reduction strategies based purely on hedging one SBBS with another. This is worthy of further investigation.

It is important to acknowledge that providing liquidity by relying on a parallel market for hedging requires adequate funding liquidity, regulation that permits the netting of inventory positions and broad-based diversification by dealers. Any systemic contraction in availability of funding liquidity is likely to disproportionately affect liquidity in markets that depend on hedging (see Brunnermeier and Pedersen 2009). It is important therefore that dealers have adequate capital to withstand relatively large shocks.<sup>13</sup> Regulation that prevents netting of positions of intermediaries would constrain positive liquidity spillover effects. Similarly, large changes in correlations can magnify risks during a crisis so trading systems need to be dynamically flexible and capable of managing such complexity. This may increase operational costs.

One important policy implication of the analysis above 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

<sup>13</sup> It has been shown by Baranova et al. (2017) that recent tightening of capital and leverage requirements of financial intermediaries has damaged liquidity provision during calm markets' conditions, but it has helped to protect liquidity during crises' circumstances. Getting the balance right is therefore crucial.

likely to occur. There is obviously a trade-off here between specialisation, which helps to make price discovery more efficient, and diversification for risk managemen<sup>t</sup> purposes.

**Funding:** This research received no external funding.

**Acknowledgments:** I am grateful to Sam Langfield, Marco Pagano, Richard Portes, Philip Lane, Javier Suárez, Kitty Moloney, Patrick Haran, Angelo Ranaldo, Thomas Reininger, Martin Phul and members of the ESRB High-Level Task Force on Safe Assets for helpful comments. Views expressed are those of the author and do not necessarily represent the views of the task force. Technical assistance from Paul Huxley at Matlab is also gratefully acknowledged.

**Conflicts of Interest:** The author declares no conflict of interest.
