Study On Endogenous Liquidity Of Bond Market In Market Maker System

Market maker system is widely adopted in mature capital markets as thetrading mechanism, which is also the main trading system in China’s inter-bankbond market. However, compared with the mature ones, China’s market makershave the lower quote frequency and the bigger bid-ask spread, which leads to theliquidity problem in China’s inter-bank bond market. Liquidity plays animportant role in measuring the operation quality of bond market. The study ofliquidity is always associated with price discovery, that is, the core of marketmicrostructure. Thus, through the thorough study on liquidity, we can have abetter understanding in price discovery. All in all, by studying the innerrelationship between liquidity and price discovery, we provide policyrecommendations aimed to make the trading mechanism better and to improvethe bond market liquidity and efficiency.Firstly, this paper summarizes and reviews literatures on market makersystem, capital market liquidity and price discovery mechanism, after which thispaper analyzes the models and methods on the study of capital market liquidity.Secondly, by considering the characteristic of bond’s formation process of price,the paper improves the original endogenous liquidity model. Based on theimproved model, this paper randomly selected20national debts that are traded inChina’s inter-bank bond market as samples. The empirical results showthat endogenous liquidity theory fits China’s inter-bank bond market. Theprinciple of the theory is that the larger deviation from fundamental valueendogenously decides the amounts of market makers. Then the entry of marketmakers accelerates the reversion rate of the capital price. Plus, before and afterinterest distribution, the verification of endogenous liquidity is different.Furthermore, we find that the quote continuity of market maker is one of theimportant determinants of the endogenous liquidity theory. Also, the quotecontinuity promotes the process of price discovery that caused by informationflow. Finally, based on the results of empirical analysis, this pater puts forwardpolicy suggestions aimed to improve China’s inter-bank bond market endogenousliquidity, such as promoting the link between inter-bank bond market and stockexchange bond market, improve market maker system and so on.