Primary dealerships: a broken model or just in need of a tune-up?
Credit Suisse’s exit from European primary dealerships once again raised the question of whether the business is sustainable for banks. As the cost of providing secondary market support rises thanks to growing regulation, volatile sovereign bond markets and other factors, more exits appear inevitable. Craig McGlashan reports.
Government financing has existed for about as long as the banking system itself. But senior bankers in the sector believe that the model as it stands cannot go on for much longer.
Every head of DCM polled by GlobalCapital (see page 18) expects more banks to exit primary dealerships this year — with most predicting two departures.
Before that poll was taken, Credit Suisse announced in October 2015 that it would be relinquishing its European primary dealerships and exiting secondary market making in European government bonds. A few weeks later, Deutsche Bank was dropped from Belgium’s list of primary dealers. The German bank subsequently confirmed its commitment to its other primary dealerships — but many bankers believe such events are symptomatic of a wider problem with the model.
“The primary dealership model is not sustainable,” says a head of SSA DCM in London. “There’s a clear disconnect between functioning government markets and what we have now. One of the fundamental principles that banks were created for was to finance government debt. “If that isn’t working it needs to be addressed.”
One particular bugbear cited by several SSA bankers is the auction model sovereigns use to raise the bulk of their financing. As banks aggressively bid to buy paper at auction and so push themselves ahead of others in the queue for lucrative syndication mandates, there is a risk of costs spiralling out of control, says another head of SSA DCM.
“Let’s say a bond is trading at par in secondary,” he says. “During the auction you have to bid versus all the other banks, so you bid at a level over par, which costs you as the price goes back to par after the auction.
“The reason you take that cost is to get league table position with the sovereign so you can win underwriting business. Sovereigns say that they’re trying to dissuade banks from doing it, because they realise the more it happens the less economic it becomes. But they’ve been saying that for 10 years. “It accumulates and makes it very expensive to be a primary dealer. The risk is that more banks leave.”
Sovereign bond markets are still enjoying support from loose central bank monetary policy — even as the US Federal Reserve begins to tighten. That means the danger of a shrinking primary dealership market could begin to bite issuers further in the future, some bankers warn.
“Overall, sovereigns made it well through the eurozone debt crisis, with support from dealers when times were tough,” says the first head of SSA DCM.
“Because of quantitative easing, to a degree, yields are low and issuance is fairly easy, but I wouldn’t take that for granted. It wouldn’t be beyond the realms of possibility to have a different world in a few years’ time. There could be less liquidity and fewer banks willing to take down debt. That’s clearly a worry for the industry as a whole as well as individual issuers.”
Sovereign funding officials say they are aware of the problem — and are taking steps to avoid future calamities.
“The sub-committee on EU sovereign debt markets of the Economic and Financial Committee has become more active in speaking to authorities and regulators to tell them to be careful and ask if they’ve thought about the unintended consequences on liquidity of the new measures they are considering,” says Maria Cannata, director general of the public debt directorate in the Italian Treasury in Rome.
A third head of SSA DCM feels that onerous regulations, which make secondary market making more expensive for banks, is one of the biggest problems facing the model.
“Regulators aren’t pulling back so sovereigns are getting more reliant on central bank buying,” he says. “US swap spreads have gone negative, which was partly in anticipation of a rate hike by the US Federal Reserve, but one of the big moves was because central banks sold bonds over the summer and the market couldn’t absorb it as there wasn’t enough capacity.
“That led to a big reaction in secondary markets and arguably led to the mispricing of US Treasuries, which are supposed to be the most liquid bonds. The European market is even less liquid so there will be an even bigger impact.”
The SSA DCM head believes eurozone sovereigns will have to get together to sell a joint bond in order to generate liquidity.
At a national level, he suggests that issuers could tweak their auction process.
“They could move to a model like in the US with direct and indirect participation, which allows more disintermediation as larger asset managers are able to purchase debt directly from debt management offices,” he says.
Other potential solutions banks and issuers are suggesting include regularly tapping the market with smaller deals, taking some of the cost burden of warehousing risk after auctions from the banking sector. Private placements could also be used to directly tap specific investor demands.
But the challenges for banks are also creating opportunities for disruptive technologies. Electronic market makers, such as Citadel, a large player in equity and futures markets, are looking to break into the US Treasury market.
With MiFID II rules set to require dealers to make firm prices to market for benchmark size sovereign bonds and print trades to a reporting venue afterwards, crucial information — the true price of a trade — will become widely available, which could make it easier for electronic platforms to take some of the liquidity business from the banking sector.
Smaller is better?
Some bankers argue that a smaller primary dealership market may be for the best. That would leave a group able to offer the best possible service. Some banks have not been extremely active in primary dealerships, they say, because it is not a part of their core business. The increased costs mean it is increasingly unlikely they will stay.
“If banks have been low performers and not contributed a lot, in terms of aggressive bid/offer spreads or the depth of their client base, it probably won’t have much of a dramatic effect on the market if they leave,” says one SSA DCM head. “There’s probably a bit of room for consolidation without too much damage.”
But while a few banks leaving over a long period of time may be good for the industry, there is a serious risk if lots of them decide to exit all at the same time.
“What we desperately want to avoid is six fat boys running for the exit at once,” says one prominent market participant. “It will create panic, and make others — whose business models might be perfectly profitable — question what they are doing in this business.
“But the fact is that the cost of the business has gone up, so the returns have to go up otherwise it shuts down. The days of having banks intermediate markets constantly are over. Can we restore liquidity levels to pre-crisis levels? No we cannot.”
It is not only competition at auctions that has made being a primary dealer and offering the required secondary market support more expensive.
The International Capital Market Association has warned that regulation has made banks more discerning over capital allocation, which means they have been running smaller inventories.
Basel III capital and leverage regulations and the Volcker Rule are among the regulations market participants cite as contributing to increasing costs.
“Rules and regulations have made it prohibitively expensive to hold positions, which leads to balance sheet charges,” says another head of SSA DCM.
“That leads to an advantage for bigger players. It suits some of the domestic players and larger balance sheet banks that can leverage off of cheaper, more accessible balance sheet.”
Additionally, the sovereign bond market has become increasingly volatile (see graph), making it even more expensive to provide the necessary support for sovereign bonds.
Banks trading in sovereign bonds can easily lose a lot of money if the market quickly turns against them — as it has with growing frequency over the last year.
All of those extra costs are coming on top of a model that is already extremely expensive from a headcount, technology and capital point of view.
But while many market participants voice their concerns about the primary dealership model, others are confident that it will survive.
“The primary dealer model can continue to work, including a well-functioning secondary market, although costs have certainly increased,” says Lee Cumbes, head of SSAR DCM at Barclays in London.
“Industry trends, often driven by reforms, have led banks to be more thoughtful and strategic around returns and capital. Good primary dealers perform a very important function for governments.
“They buy the debt in a consistent fashion and offer markets to investors on both good days and bad days. It’s a system that has worked well over many years and, as such, has high value.”