The concept of liquidity has changed over the course of the financial crisis. Where once it may have been viewed as a free ticket, it is now highly valued for without liquidity there cannot be a market. Covered bonds are comfortably at the most liquid end of the credit spectrum, but the way they are traded has completely changed since the onset of the financial crisis.
Before the collapse of Lehman Brothers, issuers contractually obliged their arranging banks to make markets on all the deals that they were mandated for. These arrangements were often strictly enforced, with dealers signing up to agreements that were, at times, impossible to implement.
This system was difficult to monitor and enforce. After being regularly abused, the crisis revealed the charade for what it was and contractual market-making obligations were dropped.
These obligations had forced traders to quote in a minimum size, for a specific time during the day and at a pre-agreed bid-offer spread. But nowadays the decision is left down to the individual bank.
The fact that the secondary market can still function despite sudden volatility spikes "is a reflection that the system is in a relatively healthy place but it has structurally changed," says Julia Hoggett, managing director, head of FIG flow financing, EMEA, at Bank of America Merrill Lynch in London.
Before Lehman Brothers collapse, banks would trade with each other under a system known as head to head. But following the events of 2008, this system came in for severe criticism as banks realised they were effectively giving their balance sheet away to their competitors. These days, liquidity that banks choose to provide is principally for their own customers.
"Nowadays there isnt the obligation to spend all day fielding calls from other market makers," says Jez Walsh, global head of Royal Bank of Scotlands covered bond syndicate in London.
Instead flows "go to the guys who are able to turn bonds, and who know where to find investors to cover their shorts," says Thomas Lay, head of covered bond trading at Natixis in Paris. "But we live in a different, risk-adjusted world which is positive as it means we can quote only as tight as underlying hedges."
And, from a clients perspective, Lay maintains that there is still good liquidity and that competition among top 10 dealers is high. "Very often you have to move to mid-market to get the deals done," he says.
Freedom of movement
Had contractually forced market making and the head to head convention continued to this day, its likely that the market would have regularly seen episodes of paralysis.
But by being able to change the bid-offer spread according to risk tolerance, "paper still has a chance to move freely and thats important," says Hoggett.
Liquidity is not about "the last person to sit on the chair before the music stops," she adds, but rather about facilitating the movement of bonds around the market to match buyers and sellers, and if necessary hold on the balance sheet in the interim. But if traders cannot move paper on, its unreasonable to expect them to exceed credit lines and buy more.
Though at times bid-offer spreads have been very wide and dealers have been uneasy to quote in large sizes, Mauricio Noé, head of covered bond origination at Deutsche Bank, says "we shouldnt beat ourselves up".
"The market has been going well for best part of this year and lots of risk has been put on," he says. This is, in no small part, helped by the strong primary market that has created a lot of on-the-run bonds and valuable pricing references.
A straw poll of the top five league table houses suggests average weekly turnover of around 1.5bn. Taking account of the remaining dealers and additional business conducted over electronic platforms, secondary traded covered bond volumes for the European market as a whole could well exceed 10bn a week.
As good as that sounds, there are "enormous gradations of liquidity," says Hoggett. These levels change over time and can be affected by many factors, but ultimately its their risk tolerance that is the key.
As perceptions of risk have changed, so have average ticket sizes and bid-offer spreads. In the case of the sovereign market, typical secondary market transaction sizes for Portuguese and Irish government bonds are in the 3m-5m range today, versus 50m two years ago.
More recently, the rout in Italian BTPs sucked liquidity out of the Italian covered bond market and covered bond deals issued by the national champions. Trades had typically been in ticket sizes of up to 30m but are now only quoted in 5m-10m tickets.
The willingness to provide liquidity and extend credit directly affects the velocity at which cash is moving around the overall financial marketplace. This means that when a negative headline hits the market, a feedback loop can quickly become established as dealers collectively shut up shop.
This was particularly evident after the collapse of Lehman Brothers, when the global banking sector was short of cash "at exactly the point people wanted to shift large positions," says Hoggett.
The speed with which liquidity dried up was partly informed by the earlier failure of Bear Stearns. Bankers that were slow to cut their positions and rein in their balance sheets when Bear Stearns failed, were heavily penalised. When the subsequent run on Lehman Brothers got underway, they had learnt their lesson and ran for the exit more quickly.
"Since the collapse of Lehman Brothers, banks have learnt to become more sensitive to liquidity constraints and the deployment of their balance sheets," says Deutsches Noé.
In stressed financial circumstances when liquidity provision retreats quickly, banks will tend to service only their most trusted core clients closest to home, leaving all other market participants to fend for themselves. This is illustrated by the Danish, Swedish and German covered bond markets, which continued to function at the depths of the crisis due to their exceptionally loyal and deep domestic investor bases.
According to the Association of Danish Mortgage Banks, the Danish mortgage market has had a broad and stable investor base for decades. Some 58% of the Danish covered bonds are held by domestic financial institutions, typically commercial banks that are headquartered in Denmark and a further 19% is held by domestic pension and insurance companies. This means that close to 80% of Danish covered bonds are held by Danish institutional
The association says that covered bonds are a material instrument in the liquidity management of Danish financial institutions. As the investor base has been stable for decades, the mortgage market is liquid and deep at all times, making covered bonds the ideal instrument for banks to hold as part of their liquidity buffer.
Covered bonds as a liquidity buffer
Faced with the dilemma that liquidity can easily disappear, regulators are trying to hard-code the proportion and type of liquid financial instruments that a bank must hold on its balance sheet for liquidity purposes.
Basel III and its transposition into European law, the Capital Requirements Directive IV, try to specify exactly what financial instruments qualify as liquid.
If banks hold enough of the right sort of assets on their balance sheets, regulators hope they will have a reserve of liquidity to draw on in times of wider financial market stress. But by trying to assign assets a liquidity value based solely on their name, regulators have come in for some criticism.
Under Basel III and CRD IV, sovereign bond markets were put on a pedestal and categorised as an eligible level one asset within the Liquidity Coverage Ratio, making these bonds collectively more liquid in the regulators eyes than covered bonds. There is no limit to the amount that can be held in the liquidity buffer and no haircut.
But, with Greek, Portuguese and Irish government bonds trading at discounts of up to 50% and getting transacted only in small sizes, there is evidently not much liquidity in some government bond markets.
Being a level two asset under the LCR, covered bonds enjoy a less privileged position than sovereign bonds. Banks are restricted to holding up to a maximum of 40% of their liquidity buffer in the form of covered bonds, and must apply a 15% haircut to the valuation.
Not surprisingly, Danish banks, which collectively hold 58% of domestically originated covered bonds on their balance sheet, were up in arms with the Basel III proposals when they were released in December 2010. Draft regulations would have required them to sell around one third of their holdings to bring the level down to the prescribed 40% limit.
Had Danish banks complied, regulators could have sparked a Danish banking crisis.
However, by the time the redraft of CRD IV was released in July 2011, a get-out clause had been included. According to Article 481(1) the European Banking Authority (EBA) must monitor and report on all cases where the application of liquidity requirement regulations has a "material detrimental impact on the business and risk profile of Union institutions, on financial markets or the economy and bank lending".
Barclays Capital covered bond research analyst, Fritz Engelhard, says this wording may allow authorities to amend certain liquidity management rules for countries like Denmark, Sweden and Germany which have a large proportion of specialist mortgage banks.
The EBA will report on proposed definitions for level one and level two assets by the end of 2015 and in December 2016 the EC is expected to submit a legislative proposal.
Engelhard says the CRD IV draft is a positive, as it takes into account that secondary market liquidity "is not purely a function of the asset type and ratings but subject to a more complex set of criteria".
Apart from ordaining what banks should hold for liquidity purposes, regulators are also anxious to make sure that all investors get equal access to liquidity. According to Elizabeth Callaghan, former head of market structure at Amias Berman, there is "a tiered system of liquidity in place for investors".
But Callaghan believes this tiering will become less pronounced with the introduction of the Markets in Financial Instruments Directive 2 (MiFID 2), which is likely to call on bank dealers to report on the secondary market levels they have traded bonds at.
Such reporting could "cause a tightening of bid-offer spreads and create greater competition between banks and brokers," says Callaghan, which is "of course the aim of Brussels."
MiFID II aims to provide fixed income markets with a level transparency that is similar to the equity markets, and transaction reporting is likely to be the starting point.If the transformation of equity markets is anything to go by, fixed income markets could see commission sharing agreements that demonstrate best execution, along with high volume/low value electronic trading platforms, which Callaghan says "are already surfacing on some exchanges."