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As the role of fiscal policy continues to expand, the issuance of the Korea Treasury Bond (KTB) is increasing rapidly to raise funds for government spending. Consequently, the secondary market for KTBs is becoming more important. Improving the secondary market's price discovery function not only helps the government raise funds efficiently, but also has a positive impact on the primary market.

Liquidity is a key indicator of secondary market conditions. Given the growing importance of the secondary market for KTBs, there is a need to meticulously analyze the factors affecting the KTB market liquidity and the impact of a liquidity shock on the KTB market. This paper examines the structure of the KTB market, focusing on the secondary market, and analyzes the factors affecting KTB liquidity and the impact of a liquidity shock on KTB yields and volatility with the construction of a liquidity index.

The KTB secondary market can be divided into the exchange-traded and over-the-counter (OTC) markets. Almost all KTB trading takes place in the KRX (Korea Exchange) KTB, an inter-dealer exchange market for KTBs, and the OTC markets. These two markets differ significantly in terms of the main purpose of transactions and participant characteristics. The KRX KTB market is characterized by active trading among primary dealers, particularly for benchmarks (on-the-run). On the other hand, the OTC market accommodates diverse institutional investors engaging in the trading of a variety of KTBs, including non-benchmarks (off-the-run). Hence, these significant differences in each secondary market need to be considered for the analysis of the KTB market liquidity.

We estimate a KTB market liquidity index using trading data for benchmarks from the KRX KTB market. Our analysis reveals that market liquidity is highly affected by changes in financial market conditions, exhibiting significant time series variations. In particular, market liquidity deteriorated substantially in March 2020 during heightened market volatility prompted by the shock of the COVID-19 pandemic. In addition, from September 2022 to January 2023, a period marked by escalated uncertainty in global financial markets due to the intensive monetary tightening by central banks in major countries, there was a notable decline in market liquidity. Meanwhile, the liquidity indexes of different maturities are highly correlated, suggesting that changes in financial conditions are the main drivers of liquidity, rather than the idiosyncratic characteristics of a particular maturity.

The regression analysis of the impact of financial conditions on KTB liquidity shows that market liquidity is significantly affected by changes in domestic and global financial market conditions. Not only domestic market conditions such as credit risk and funding liquidity, but also overseas market conditions such as the US dollar index and volatility in the US bond market and stock market exert a significant influence on KTB liquidity. In addition, a decrease in KTB prices contributed to a deterioration in liquidity, while an increase in prices improves liquidity suggesting that investment profits and losses also have an impact on liquidity.

Subsequently, we analyze the dynamic impact of a liquidity shock on the KTB market using a VAR (Vector Autoregression) model. The impact of a liquidity shock persists for a period spanning three to four weeks following the shock. These results indicate that it takes a significant amount of time for the KTB market to recover from liquidity shocks. It also suggests that when liquidity shocks accumulate over a short period of time, the vulnerability of the KTB market rises.

Based on the analysis in this paper, there are several implications for KTB liquidity. First, the growing importance of the secondary market for KTBs calls for the development of comprehensive liquidity indices capable of capturing variations in liquidity across the KTB market, and further research on methodologies is necessary to estimate liquidity indices more accurately. Next, given that KTB liquidity varies significantly in response to changes in domestic and overseas financial conditions, more attention should be paid to the KTB liquidity during periods of deteriorating financial market conditions. The government and the Bank of Korea need to prepare effective policy tools to mitigate excessive deterioration in liquidity when market liquidity worsens due to exogenous factors. In addition, continuous efforts are needed to improve the efficiency and transparency of the government bond market structure. Finally, it is necessary to expand the demand base for KTBs through the diversification of KTB products, as a broader investor base can increase market liquidity and mitigate liquidity shocks.