Few topics excite an ABS audience like covered bonds. Attitudes range from bemusement to jealousy, taking in admiration and contempt.
ABS market participants get particularly incensed by the regulatory treatment of covered bonds. They fume that the European Covered Bond Council has the Bundesbank (and hence the ECB) by the balls. They sit in awe of the awesome lobbying power of the covered bond market, and wish securitisation could speak with one voice.
So when the European Securitisation Forum started designing an initiative to ease the regulatory ire against securitisation, it was natural to look to covered bonds, and natural to look at the market-making commitment — a classic piece of self-regulation.
Pre-crisis, banks managing the sale of a jumbo covered bond had to agree to quote prices up to €15m tickets with defined maximum bid-offer, depending on maturity. They had to quote publicly on Reuters and Bloomberg, and offer their liquidity to whoever asked.
Which was fine, except it didn’t work.
Just like an ordinary asset class with no market-making commitment, liquidity disappeared when the crisis hit. Actually, because traders were keeping to the letter of the law if not the spirit, spreads shot wider much faster. Restrict freedom of manoeuvre in one direction by forcing market-makers to quote in size to everyone, and spreads will slip.
Without a market-making commitment, dealers would be free to quote at one level but not to trade in size. The market is no more illiquid, but bonds don’t get marked down.
A market-making commitment doesn’t produce more liquidity, unless dealers are willing to commit more resources to market-making or take on more risk. It just reshapes the liquidity already available.
Parts of the ABS market are now looking at including this abomination in the Prime Collateralised Securities initiative being promoted by Afme and the European Securitisation Forum, among others. Prove liquidity via such a commitment, the theory goes, and regulators will relent. With regulatory favour comes the great white hope of the ABS market, that PCS-endorsed ABS could go in bank liquidity buffers under CRD IV.
If that were to happen, it would make a real difference to liquidity in the market. If banks could use ABS to manage their regulatory liquidity needs, many more bidders would be active in the market. And they would roll their portfolios more often, offer more assets for repo, and take down larger tickets.
It would be a real improvement in liquidity, not window-dressing. So a market-making commitment in PCS would put the cart before the horse — the illusion of liquidity, in the hope of getting real liquidity later.
But regulators shouldn’t ask for this, and the market shouldn’t offer it. Let ABS count for the Liquidity Coverage Ratio, with a quality endorsement label if necessary, and watch the liquidity flow in.