Over the past three years, sovereign, sub-sovereign, supranational and agency markets have undergone profound changes in liquidity conditions. As the European Central Bank has shifted from the position of marginal buyer to draining liquidity from the system through quantitative tightening, the private sector has been forced to absorb and warehouse a greater amount of issuance. For almost half of respondents to OMFIF’s 2026 Public Sector Debt Outlook Survey, secondary market liquidity ranks as a top three funding concern.
Their concerns reflect the evolving landscape of sovereign and SSA markets. As the ECB has stepped back from liquidity provision, increased rates market volatility and regulatory changes have made intermediation more expensive. Primary dealers are facing increased demand for their services as market-makers, precisely as these services have become more expensive to provide.
NBFIs as liquidity providers
To an extent, non-bank financial institutions, particularly asset managers and hedge funds, have stepped into the market, somewhat alleviating downward pressure on secondary market liquidity. Survey respondents expect this to continue, with results showing a greater expectation for NBFIs to play a larger role in primary and secondary markets in 2026, relative to 2025.
However, this solution comes with its own challenges – the same institutions that provide liquidity are prone to withdrawing it under stress conditions. ECB research suggests that sovereign yield volatility is correlated with the proportion of a sovereign’s debt held by foreign NBFIs. During times of sovereign stress, NBFIs located outside the euro area face larger withdrawals from their investors and sell more debt of the most affected countries, as measured by changes in their credit default swap premia – a market measure of their default risk. France felt the brunt of this problem during its multiple political crises in 2025.
Constraints on the primary dealer
While NBFIs can bolster liquidity in some markets at the margin, to a large extent, secondary market liquidity remains determined by the capacity of primary dealers to warehouse risk and intermediate trades. It is the dwindling of this capacity that most concerns our survey participants.
When asked which aspect of market structure they would change to improve funding conditions or secondary market liquidity, some answers pertained to fiscal consolidation in France or advancing European post-trade and market infrastructure integration. Most responses related to facilitating primary dealer intermediation. Some wrote specifically about regulation, but all were focused on alleviating balance sheet constraints and freeing up risk warehousing capacity.
Recurrent geopolitical risk events, trade-related uncertainty and the shift in monetary policy have all contributed to a more volatile rates environment since 2022. This makes market intermediation more capital intensive. Under the European Union’s Capital Requirements Regulation, dealers are required to hold market risk capital against positions in their trading books, with capital requirements calibrated to potential losses over a given horizon. When rate volatility rises, so do the expected potential losses against which capital requirements are calculated. Mechanically this increases the capital that needs to be held against any given position, even the safest sovereign or SSA bond.
Dealers seeking to warehouse inventory and provide two-way prices in size face compression of their return on capital from intermediation activity, due to its corresponding capital demands. Crucially, this squeeze on intermediation capacity is most acute at the points in the cycle where balance sheet capacity is most essential to smooth market functioning. Volatile markets require market-makers willing to facilitate trading.
Additionally, the non-risk-based leverage ratio implemented under CRR imposes an absolute capital floor of 3% – meaning banks are allowed just over 33 times as much in total economic exposures as they hold in Tier 1 capital. This can increase the opportunity cost of low-risk, high-volume activity, such as sovereign and SSA market intermediation. For the largest primary dealers, designated global systemically important institutions, leverage ratio surcharges – incremental capital requirements beyond 3% – may compound this effect, perversely disincentivising the intermediation that supports the functioning of the most systemically important markets.
The effect of the leverage ratio requirements on intermediation capacity is difficult to estimate precisely, but research from the ECB suggests that it can become binding in a manner that impacts intermediation capacity, particularly during times of stress.
Regulatory solutions and their limits
There is no simple fix to the impact of these constraints on secondary market liquidity. Although some market participants advocate for the exclusion of certain securities, in particular sovereign bonds, from market risk-related capital calculations and from leverage ratio exposure measures, such solutions come with their own problems. The ECB advocates greater use of central clearing by primary dealers. Centrally cleared positions can be netted under leverage ratio rules, thereby reducing the burden of capital requirements for low-risk intermediation without requiring changes in regulation.
While tension between prudential regulation and market functioning is not new, its effects are being amplified by changing market conditions. As sovereign and SSA issuance volumes grow again this year, and dealer intermediation capacity remains constrained, problems may intensify. As our survey results show, market participants are concerned. Regulators should take their concerns seriously before market reality forces them to do so.
Conor Perry is an Economist at OMFIF.
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