The straining, age-old business model that has governed how dealers operate in the sovereign, supranational and agency bond market finally cracked in November after years of growing pressure.
UBS said it was quitting the business, blaming the excessive costs of taking part for its shock exit. Many other banks not least of all SSA powerhouse Barclays are under increasing pressure to achieve better returns from ever more scarce capital.
The fact is bankers and the shareholders that ultimately pay their wages do not want to throw capital and talented staff at a business that returns only meagre profits regardless of how high profile and prestigious that business is.
But although the nature of UBSs demise was a shock to almost everyone in the SSA market, the fact that a top five institution finally decided to walk away from this most core of businesses was not wholly surprising.It is not just SSA bankers that are troubled by the sustainability of their business either. Issuers can see the writing on the wall. One senior funding official at one of Europes biggest SSA credits tells EuroWeek that the potential for banks to follow UBSs lead and leave the SSA market is his primary concern for the year ahead.
Senior SSA bankers have warned for years that the costs of sovereign primary dealerships, the increasing costs of capital usage for underwriting and above all, the price of derivatives trading with SSA clients could seriously damage the health of their market.
But there were signs before UBS closed down its SSA franchise that previously stubborn issuers were starting to understand, sympathise with and react to bankers pleas, in particular with regard to the derivatives trading cost problem.
Some borrowers have come round to bankers way of thinking on a number of key issues, such as the introduction of two-way Credit Support Annexes (CSA), which govern the costs of derivatives trading between a bank and its SSA client.
But there are many others that still refuse to sign two-way CSAs and in so doing are preventing the market from becoming the robust and healthy place it once was.
Not only do interest and cross-currency swap trades form a key part of pretty much any SSA deal by securing the cost of funding for an issuer over the life of a bond deal but they also offer issuers a chance to manage the exposure of their portfolio of debt. The ability to price a swap competitively has a big influence on a banks ability to win a bond mandate.
Issuers have acknowledged that UBSs inability or unwillingness to compete on this aspect of the new issue business cost the Swiss firm mandates.
The CSA determines which counterparty in the swap pays collateral to whom when the trade is in or out of the money as interest rates fluctuate over time. Typically many SSA borrowers, having superior credit ratings to their dealers, have insisted on having one-way CSAs, whereby if the bank is out of the money, it must post collateral to the issuer to cover it, but where the issuer does not have to do the same if the trade favours the bank.
Sovereigns have argued that they have infinite access to money and so posting collateral to a bank is pointless. Meanwhile, supranational and agency issuers have offered a whole range of arguments from inability to run a full collateral management operation to their superior credit rating as reasons why they should not post collateral. But as the regulatory environment has shifted in the wake of the 2008 banking crisis, so has the cost of providing that collateral. Whereas banks could previously waive the cost of capital used for collateral in a swap, this is no longer the case.
Banks not only have to find collateral to post, but they must also have reserves for when they are in the money and not receiving anything from their SSA counterparty.
The costs of this can often exceed any P&L available on the bond mandate, especially on the cross-currency swaps that facilitate almost all arbitrage funding that SSA borrowers attempt.
A two-way CSA with zero thresholds whereby both counterparties have to post collateral to each other when they are out of the money regardless of the credit rating differential mitigates against these costs and bankers have been desperately trying to persuade SSAs to sign them.
There has been progress made over the last couple of years. Senior bankers say that almost all agencies are now signing or are about to sign two-way CSAs, many with zero thresholds. Network Rail is one example of a borrower that took the Bank of Englands lead and is switching to two-way CSAs with all of its dealers.
"We think it is the best policy as it puts everyone on a completely level playing field," says Samantha Pitt, group treasurer at Network Rail in London. "From an issuers perspective, it means my hedging costs are significantly reduced and I will be able to hedge with more counterparts."
The key CSA battleground now lies between the supranationals and the banks, say senior SSA bankers, with just three ringleaders preventing the group from signing two-way CSAs and putting to bed the issue for once and for all.
Bankers say the World Bank, the EIB and the Asian Development Bank are the only issuers now reluctant to budge and give up their one-way CSA arrangements. The other institutions, in private at least, acknowledge the need to move to two-way CSAs.
"I think it is the way the market is going and I think well move over eventually," says one supranational funding official. "But it needs other supranationals to act too and that is a political matter."
But senior bankers point out that despite their protestations, the cost of trading is still not being passed on to supranational clients. "The cost of a one-way CSA on a swap can be substantial," said one head of capital markets. "But last year, issuers still went about their business as usual."
The World Banks view is that it is premature to sign up for a more costly operation where it must start posting collateral when it is still unclear what the final regulations for banks will be and while it is still not affected by changes in derivatives pricing.
"Banks bring up the topic of two-way collateral," says Heike Reichelt, the World Banks head of investor relations and new products in Washington DC. "We are still studying the issue and do not think it is right to change before the final regulations and possible exemptions are clear. Some banks are taking into account the regulations in different ways and although weve seen bigger differences in pricing than before between banks, we are still able to get very competitive pricing."
Also in favour of the one-way holdouts is the fact that there are always new banks trying to win market share and playing fast and loose with their capital in order to achieve it.
That gives those issuers still on one-way agreements a strong case to argue that switching to two-way CSAs is unnecessary. But that is a rather short-term argument if one accepts that the current, more expensive cost of capital is a truer reflection of the risks involved in running derivatives positions and that the move to new tougher capital restrictions is irreversible.
After all, what are these issuers doing if not loading a number of banks up with the very same set of problems that came to hit the bulge bracket firms over recent years?
"Its all very well running to senior management as a borrower and saying Look! I saved a few basis points," says one head of SSA debt capital markets. "But that trade is going on the books for five maybe 10 years. If it all goes wrong, youre not going to look like such a hero when youre applying to be the group treasurer or CFO."
The problem of capital usage in derivatives trading, however divisive, is at least on the road to resolution. The same cannot be said for the problem of the costs of sovereign primary dealerships. Bankers are struggling to overcome inertia and public perception problems as they hope to persuade sovereign bond issuers that the era of dealer-subsidised auctions should end. But if they can, the market would be left a healthier and more transparent place.
For years, sovereign issuers have milked the fact that banks and their clients view a primary dealership almost as a necessity for transacting other business in a countrys bond market.
Bond bankers have justified to senior management a primary dealership spend by pointing to the ancillary profits to be made in related markets. But that pot is dwindling.
"If I look at each of my primary dealerships and look at whether they are profitable, on their own, many are loss making," says one head of capital markets. "If I look at the auction costs versus the fees I earn on subsequent sovereign syndications, I usually still make a loss. Against flow derivatives for that sovereign, I make a loss. Against event derivatives for the borrower I make a loss, sometimes a small profit. Even if I look at the cost of the fees I earn on agency syndications from that country, it still does not compensate me for my auction spend."
Instead the arguments to retain or grow market share in auctions are becoming ever more subtle and, frankly, tenuous. "Keeping a high dealer ranking and buying market share keeps us relevant and in the flow," says a senior SSA originator.
Of course, when planning and advising on which new issue strategy an agency should pursue it can be no bad thing to know which clients are buying or selling the relevant government bonds and in which size and maturity. But should that really justify distorting government bond markets and spending vast sums of the firms profits just to save sovereign borrowers a few basis points?
After all, the wider shocks that have rocked government bond markets in recent years especially in Europe have dwarfed in yield terms the scrimping and saving made by borrowers who, alongside price-chiselling investors expecting something for nothing, consistently force dealers to tie up capital at the wrong price in government auctions.
Such practice will eventually drive experienced bankers and possibly whole banks, as has already been seen with UBS, into other more profitable markets. This would leave the sovereign bond markets as weaker places, populated by banks allowed to grow fat, lazy and inefficient through a lack of competition.
Moreover, in such volatile times, it hardly seems responsible to the taxpayer for sovereign borrowers to encourage the market into such a design where the bankers tasked with supporting public debt are inexperienced or generalists.
"There is no value given to long-term relationships by and large," says one head of SSA origination. "Publicly, sovereigns will say they consider all sorts of factors when rewarding dealers but privately theyre on the phone hauling you over the coals for dropping down the league table, which forces you to spend more buying bonds at the wrong price."
Investors have come under similar fire for playing dealers off against each other knowing that banks are competing for market share. For investors to create price tension by haggling like this is less problematic for the market as a whole, say bankers. Rather, it is for the issuers to work to ensure the health of their markets. But bankers still decry the lack of reward for good advice. Unfortunately, however, the public relations obstacle of a public employee being seen to work in favour of investment bankers is one that not many sovereign funding officials are willing or able to overcome.
Privately, however, they do acknowledge the growing problem caused by the clash between pressure on primary dealers to support and subsidise issuance versus regulators desire to make banks more prudent by ramping up the cost of capital and the amount required to do business.
"It is just one of the unintended consequences of regulation," says one head of SSA capital markets. Several sovereign borrowers are said alongside banks to be considering convening working groups to assess what the downsides of regulatory burdens such as Basel III and the Capital Requirement Directive IV might be.
But not all bankers are sympathetic with the banks predicament. "Nobody is forcing these people to write cheques this big," says one head of capital markets. "It is the banks money to do with as it chooses. Theyre not forced to take part and I dont think the penalties for doing less in auctions are as severe as many of my colleagues make out."
In fact, it is the cost of capital and the amount that will be required in future to remain in the SSA business that is at the heart of bankers worries about the future. As the cost of capital increases so will bank shareholders demand a greater return on their investment.
"The capital is not there anymore to support the wrong deals," says one head of public sector bond origination. "I have four things on my wish list that borrowers all sign two-way CSAs, that they do the right size of deal, that they do deals at the right price and that they pay more fees."
Concerns about underwriting deals were high in dealers minds last year. The European Central Banks (ECB) longer term refinancing operations (LTRO) helped address that problem by flooding banks with such an amount of cheap cash that dealers could underwrite and bank treasuries could buy bonds to allay any fears about not being able to underwrite new issues.
But it is unlikely that the ECB will be quite so generous come the start of 2013 given the long-term effect of the LTRO on the sovereign bond yields it was in part designed to suppress was negligible.
That will heap extra pressure on borrowers to listen to dealers advice on what to bring, when and at what price. This is especially the case given that the costs of getting a deal wrong could be so much greater and result in pulled mandates rather than simply making a lead manager wear an unsold position in an undersubscribed deal.
Inevitably, this has led some bankers to call for higher fees to cope with the extra pressures they face. Also inevitably, issuers are said to have reacted strongly against any such idea.Two senior originators at different firms tell EuroWeek that the last time two banks tried to spearhead a campaign to increase fees, they were singled out for harsh treatment by SSA issuers and that this has put banks off trying the same trick again. Such excessive reactions by issuers do little to encourage open and honest debate about the state of the SSA market and are at the core of the dichotomy between the traditional, somewhat adversarial way of doing business and what may need to become a more co-operative pattern of behaviour between issuers and dealers.
Whether it is through joint investigation of the unintended consequences of incoming regulations, taking a pragmatic approach to signing two-way CSAs or relenting on the pressure to hammer a dealers P&L by way of auction subsidy or underwriting, the SSA market must start looking to the long-term consequences of the way it operates.The market has already lost one dealer under the strain of contemporary arrangements. Other banks are now scrutinising carefully whether to remain in the SSA market or to let someone else take the hit while they divert capital into more profitable business lines. A market with fewer dealers willing to prioritise the SSA business that underpins so much capital markets activity could have dire consequences, not just for the cost of public sector financing but for market stability overall.