Bond market liquidity is a worry, even at the most liquid end of the European market. Credit Suisse’s abandonment of its primary dealerships and European government bond trading has spooked the market, and left dealers and debt management offices wondering who will be next.
The business is under threat from regulatory capital constraints that raise the cost of market-making, new transparency rules that could lower the returns on offer, and central bank buying which pushing cash into the market – but removing bonds from the market, and adding to uncertainty about the eventual unwind of the purchase 0programme.
Primary dealers will have to self-regulate, downsize, and liquidity will dry up further – meaning issuers will have to step up and fill the gap.
By concentrating on benchmark issuance, and reducing the issuance of non-traditional benchmark tenors, sovereign debt managers should be able to boost secondary market liquidity.
Rather than issuing two or three benchmark 10 years in a given year, issuers should keep only one 10 year line, and keep tapping it to increase the volume of that specific bond. The same strategy could work at the five year and the 30 year point.
The more liquid the benchmark, the better the pricing should be, at least in the long term, as there should be no illiquidity premium in the price. It should also allow dealers to step back up, knowing they will have a liquid exit from any positions, and reassure investors that prices won’t gap down when interest rates rise.
Investor demand for greater liquidity through standardisation and concentration is evident from the strength of the futures market. The rising volumes in the long-established Bund contract, and the rapid rise of the BTP and OAT contracts (and, perhaps the new Bono contract) demonstrate a desire to concentrate available liquidity on a single point.
The cash markets are missing a trick by the exchanges to tap this demand with futures. Instead, issuers should harness it and use it to develop the primary and secondary cash markets – the markets that allow governments to actually borrow – instead.
Even if some liquidity returns to cash from futures, concentrating liquidity in benchmarks means drying up liquidity in off-the-run issues – perhaps a price worth paying for a return to strong liquidity at key points. Issuers will have to work with dealers to visibly reduce the liquidity in non-benchmark issues, and accept an illiquidity premium when they do choose to tap off the run.
It will also mean discipline from the issuer community – even if arbitrage opportunities, or bargain basis swaps are available in other tenors, adding liquidity means overlooking these opportunities, and sticking to the benchmarks.
It may seem counter intuitive that a governments should deliberately ignore pockets of cheap funding – improving liquidity, after all, ought to be about lowering the cost for the tax payer. Ultimately, better liquidity should mean lower costs to the tax payer, but this could take a while, and will mean short term pain for long term gain.
But in the current market environment, liquidity cannot simply be left to “market forces” – because these are now dominated by regulation and by central bank purchasing. Someone other than securities regulators or central banks therefore needs to take responsibility for maintaining liquidity in government debt – it’s a public good for the whole of the capital markets.
Banks are less willing, and less able to provide this public good, so issuers must step in.