Constraints on intermediary banks can undermine functioning government bond markets

22 September 2025

By Miguel Ampudia, Eduard Betz, Anne Duquerroy, Benjamin Hartung, Vagia Iskaki and Olivier Vergote

Intermediation services by dealer banks which help connect bond-issuing governments with bond-buying investors have become more important all over the world. This is because governments need to borrow more, while major central banks are reducing their presence in bond markets and leveraged investors such as hedge funds are, in turn, increasing their footprint. The euro area is no exception. Dealers’ capacity and willingness to fulfil their role as intermediaries is crucial for ensuring the smooth functioning of government bond markets. A decline in dealer activity could disrupt efficient market pricing, reduce liquidity and amplify market volatility in times of stress.

This blog post examines the constraints on dealers’ intermediation capacity in euro area government bond markets and their potential impact on market functioning.

Primary dealers: backbone of the euro area bond markets

Primary dealers act as intermediaries between sovereign issuers and investors. The dealers temporarily hold bond inventories to help balance supply and demand in the market. While costly, as these inventories occupy space on a dealer’s balance sheet, this activity facilitates the smooth distribution of sovereign debt to the private sector. There is a limited set of about 40 primary dealers in the euro area, selected by governments. They are generally expected to participate in auctions and can make a profit by selling the bonds on.

Dealers also improve bond market liquidity in secondary markets by acting as market-makers. This sees them buy bonds from investors who want to sell and sell bonds to those looking to buy, thus ensuring a steady flow of transactions. This intermediation allows market participants to trade without worrying about insufficient supply or demand. By maintaining liquidity and preventing price spikes caused by market illiquidity, dealers help ensure stable and efficient pricing. This is all the more important as government bond markets act as a reference for other market segments, which makes bond market conditions key for the transmission of the ECB’s monetary policy.

Demand for dealers to intermediate is on the rise

Major dealer banks have expanded their activity in this field over the past few years. However, the growth of government debt in the euro area has recently outpaced the expansion of their balance sheets and capital (Chart 1), albeit at a rate lower than historical peaks. This signals that dealers need to process more bonds for a given capacity.

Chart 1

Government debt outstanding and Primary Dealers’ balance sheet items (ratio)

Issuance by euro area governments and the EU will remain high by historical standards in 2025 and beyond, driven by fiscal expansion to strengthen Europe’s defence and infrastructure capabilities. At the same time, the reduction in portfolios of government bonds held by the ECB and euro area national central banks implies that private investors will hold a larger share of outstanding bonds. To cite one example, next year the average additional annual supply of German government bonds to be absorbed by the private sector is estimated to total around €200 billion. These private sector investors are more likely than the Eurosystem to sell or lend their bonds further down the line, which in turn requires market intermediation. All in all, the larger role of private investors, together with the rising issuance of bonds, adds to the pressure on dealers’ intermediation activity.

In parallel to all this, the growing activity of leveraged investors such as hedge funds has increased the demand for intermediation, as explained in a previous blog post. On the one hand, hedge funds help government bond auctions to succeed both by placing orders directly with dealer banks and by facilitating the offloading of dealers’ allocations after the auction. On the other hand, however, their trading strategies have contributed to elevated activity in funding markets against euro area government bond (EGB) collateral, placing greater pressure on dealer balance sheets via the repo market.

Amid these developments, the question arises as to whether dealers can elastically adjust their intermediation capacity to the changes in supply and demand.

Intermediation capacity remains in good shape

The ECB conducted a survey of dealers after Germany announced its new fiscal package in March 2025. The findings indicate that euro area dealers are broadly confident in their ability to absorb additional EGB supply without major disruptions (Chart 2, panel a).

Adding to this rather benign assessment, our analysis shows a limited correlation between dealers’ bond holdings and the EGB free float − the amount of EGBs absorbed by private investors. In the past, dealers have efficiently managed larger bond supplies without significantly expanding their inventories. This suggests that the upcoming increase in issuance is unlikely to strain intermediation or disrupt market functioning. Caution is warranted, however, as a sharp rise in issuance could trigger non-linear effects that might suddenly constrain intermediation. This could lead to higher financing costs for governments and impair the functioning of government bond markets.

Quantitative indicators, such as leverage ratio buffers and revealed capacity utilisation (current bond inventory relative to capital seen against historical peaks), confirm that dealers are on average moderately constrained. Leverage ratio headroom across euro area dealer banks − measured as the difference between actual ratios and prudential minimum capital requirements − shows that dealers maintain an average buffer of 2-3 percentage points above thresholds (yellow curve in Chart 2, panel b). The prudential capital requirement (a minimum of 3% of total exposures) relates to the total size of the bank’s balance sheet and not only to its EGB holdings.

While reassuring, this headroom also supports other bank activities and may not be readily available for bond intermediation, which is a low-margin business. EGB holdings relative to past maximum holdings indicate that dealers have recently used more of their capacity, though the ratio remains 30 percentage points below its peak (red curve in Chart 2, panel b). Proxies based on repo activity show a similar trend. However, historical peaks may not accurately reflect current capacity, while banks’ bond holdings are influenced not only by their inventory management needs but also by their own investment and trading strategies. Furthermore, internal bank risk limits also critically shape how far dealers are both willing and able to intermediate, especially during times of financial stress.

Chart 2

Soft and hard data show robust EGB dealers’ intermediation capacity

Sufficient dealer intermediation capacity has helped sovereign bond markets function smoothly, especially in the more volatile environment of April 2025 in the aftermath of US tariff announcements. During this period, there was only a slight deterioration in liquidity, in line with volatility conditions. This suggests that market intermediation was functioning properly, unlike in 2020 when liquidity deteriorated much more than expected given the level of volatility. Overall, the ability to buy or sell bonds has remained stable, and recent moves have been in line with the pattern observed since 2023.^[1]

Constraints can intensify in times of stress

Price and volatility patterns around specific events, such as reporting dates or government bond auctions, show that intermediation constraints can become binding.

Empirical evidence indicates that dealers with lower leverage ratio buffers tend to reduce their repo market activity more sharply at quarter-ends, when the ratio needs to be reported, which weakens market liquidity.

Similarly, in cash bond markets, some dealers reduce bond inventories ahead of government bond auctions to free up space on their balance sheets, which temporary pushes bond prices down. Prices typically rebound after the auction, producing a V-shaped price pattern − or an inverted V in yields − around auction dates. Such patterns sometimes called “auction cycles” are well-documented in literature on time scales of multiple days around auctions, and can also emerge intraday (Chart 3). While such price changes are usually modest, they warrant continued monitoring, especially as they tend to intensify during periods of high volatility (Chart 4).

Localised evidence of intermediation frictions around quarter-ends and auctions underscores the importance of continued vigilance and monitoring − particularly during periods of elevated market volatility.

Chart 3

Price pressures around government bond auctions

(Basis points)

Chart 4

Multi-day price pressures around government bond auctions and bond market volatility

(Basis points)

One factor that may have helped to ease balance sheet pressures on traditional euro area dealer banks over the past few years is the growing involvement of large foreign banks as well as hedge funds in providing intermediation services. Their impact on market liquidity may be mixed, however, as both foreign banks and hedge funds may retreat as intermediaries more quickly in turbulent conditions than primary dealers.

Addressing constraints structurally during normal times can help maintain resilience and avoid amplifying stress during market shocks. Authorities could encourage greater use of central clearing in EGB cash and repo markets, as well as private solutions that enable position netting. Positions that the leverage ratio rules allow to be netted do not require capital. Both measures would help to free up balance sheet space while fostering sound risk management practices.

Access to timely, detailed market-positioning and risk-exposure data is also essential for monitoring market-making and informing policy. This would help to preserve the resilience and smooth functioning of the sovereign bond market, which underpins the broader stability of capital markets and the efficient financing of the economy.

The views expressed in each blog entry are those of the author(s) and do not necessarily represent the views of the European Central Bank and the Eurosystem.

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