Primary dealerships: an endangered species

The primary government bond market as we know it is under threat. With the costs of buying bonds at auction rising and the incentives of ancillary business all but vanished, the face of government bond markets may be about to change forever, discovers Ralph Sinclair.

  • 13 Dec 2011
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Banks have bellyached about the costs of being a primary dealer in sovereign markets for years. But it has taken until the verge of collapse of the European government bond market for them to be in anything like a position to challenge the status quo.

With sovereign yields under relentless pressure in all but a handful of markets and banks shedding staff and cash by the truckload, only investors seem to be able to make any advantage out of the situation.

They can phone any number of banks they choose and expect to be offered what bonds they want in the size they want without having to pay any bid/offer spread. Meanwhile, issuers auction using a schedule that suits them rather than the investors and expect their dealer groups to take down bonds at aggressive prices and manage the position responsibly until it is sold to fill in the gap between demand and supply.

That was often a recipe for losses in stable markets and banks have always allocated portions of balance sheets and money to spend on winning market share in auctions to fight their way up the league table in the hope of payback through syndicated mandates or derivatives trading opportunities.

But the amount of balance sheet available has fallen as banks rush to deleverage. The cost of using what is left has risen as banks race to deleverage and markets are as volatile as they have ever been.

Meanwhile, the same problems of capital expense and risk reduction mean the derivatives business is often no longer profitable and many of the sovereigns that used to offer syndicate mandates no longer have the sort of market access that would allow a profitable trade. It seems no part of the business makes money and with the pressure on banks to add retained profits as core capital, many senior bankers are questioning the point of a business model designed in a different era. "Dealers are now questioning the size of the prize and the time it takes to monetise it," says Myles Clarke, co-head of global syndicate at RBS. "In the past the system was too binary. You can compete for the big wallet of swaps and syndications by getting into the top five primary dealers or so and out gunning your rivals. Alternatively you fall into the ‘other’ category where you can rank sixth or 16th and it doesn’t matter. It needs to become profitable just to be a primary dealer whether you are first or 16th."

Regulatory changes also mean that the previous holistic approach to sovereign business — that what was lost in auctions could be more than made back in derivatives and bond mandates — might no longer work even if the different pillars of that business were profitable. "As we go into a Basel III world, the idea of having blended economics across a whole firm will not work," says Clarke. "Each business unit will have to stand on its own two feet."


The first problem banks are encountering is aggressive auction pricing. Banks bidding for market share push prices higher than where the bonds trade either side of the auction meaning that banks that have not taken client orders end up long bonds at a price above where the market is trading and must then pay the cost of financing the position — which has become particularly onerous in volatile markets with more stringent capital requirements — as they try to sell the position down.

"Auctions require banks to step up and absorb risk at set times, while investors like the banks’ stocks to always be full when they choose to visit," says Lee Cumbes, head of frequent borrower origination at Barclays Capital. "When volatility is so high, this can be a challenging role."

Banks, of course, expect to have to warehouse positions as part of being a primary dealer but it is the price spikes in the auction in particular that make this a more difficult thing to do. "If a market has high auction prices, then it needs to be for justifiable and sustainable reasons or else the risks are there in the long term for the market as a whole," says Cumbes.

But it is not just a bank’s hunger for market share that drives it to put an aggressive bid into an auction. Issuers also make demands and set conditions for primary dealers to ensure sales of their debt and secondary market liquidity. However, some of these conditions can place too much of a burden on dealers which could risk market stability.

At one Italian bills auction in November, it was estimated that a bank that took its required share of bonds — 4.6% of the €5bn auction — would have lost €1.25m simply taking the bonds at pricing and cutting the position immediately. This would have been due to a combination of a price spike during the auction and the volatility in Italian markets.

"If you’re going to lose that just on a one year BOT it is horrendous," says one head of public sector debt at a bank. "There was no upside on offer and a huge opportunity to lose your shirt. People will tire of that. There is no confidence, but you have to participate and for what?"

Banks are keen for issuers to ease up on what is required of primary dealers. "Having flexibility in the system can help the market," says Cumbes. "Rules are set for primary dealers, but the more volatile the market and inflexible the rules, then the more they can feel like restrictions. If unrealistic, they could simply be ignored. A degree of more flexibility can encourage banks to do the best they can and maintain better conditions."

Slim pickings

Banks also bemoan the lack of rewards that traditionally accompanied a costly primary dealership to compensate for auction losses. With the sovereign crisis escalating there are fewer countries that can offer syndication fees with public mandates. Italy and Spain are two such borrowers that were frequent syndication users but which no longer have sufficient market access to justify such a trade.

Another casualty of the increased capital restrictions on banks has been the sovereign derivatives business. Borrowers have used swaps for liability management purposes to manage the duration of their bond portfolios. However, such borrowers have insisted that they will not post collateral to swap counterparties when a swap position is out of the money as they argue that they pose no credit risk and do not have the means to administer capital flows.

But whereas banks have waived the credit and collateral costs of these swaps in the past, many are no longer permitted to do so meaning they cannot price aggressive swaps and win this once profitable business.

The business has also suffered from a bad profile since Italian regions decided to sue banks that they claim mis-sold them derivatives trades in years past. That has made other sovereigns nervous from engaging in such reputationally unsound business with taxpayers’ money.

But not all banks are convinced that winning the long-raging argument about getting sovereigns to sign two-way Credit Support Annexes is the answer. "The derivatives carrot has not gone for good because of CSAs," says Clarke. "If an issuer has to hedge, it will have to pay the funding and credit costs of doing so. The bigger liability management trades that ended up with such a bad profile have disappeared though. Issuers do not want to be involved in those."

Pulling out

Senior bankers at systemic banks with large government bond businesses have told EuroWeek that they are now happy to consider dropping down the primary dealer league tables as they look to cut losses and conserve capital. One went as far as to say that they would consider leaving a number of smaller dealerships altogether. If a number of banks, even the less sizeable ones in government markets, did decide to pull out, issuers could risk a stampede away from their debt.

"A couple of primary dealers pulling out could have a larger knock-on effect," says Cumbes. "Adjustments are rarely linear — the market behaves like a herd."

But it seems as if what bankers are willing to say in confidence differs from what they are willing to tell issuers. One northern European issuer told EuroWeek that none of its primary dealers had threatened to withdraw and that more banks were willing to join the scheme.

The issuer also said that banks were still willing to quote aggressively on derivatives business meaning it had had little incentive to relent to signing two-way CSAs.

The German Finance Agency says it has had banks drop away from providing competitive derivatives prices but that others have taken their place. All of which suggests that as much as banks may be feeling the pain of primary dealership, they are not doing much to pass that pain upstairs to the issuers any more than they are to investors.

But bankers are sure that 2012 will be different. "A serious shake-out in markets has regularly been predicted over the years in terms of levels of competition or conditions, but often not materialised," says Cumbes.

"This year does feel different and there will be some meaningful choices for dealers ahead. The last time we were in a similar situation in 2009 the path ahead soon became clear, that finding buyers was just a matter of price. The outlook is more difficult to decipher now."

Involving investors

Given the volatility in government bond markets and how jittery it has made many investors, it is no surprise to find that the buy-side have little sympathy with banks or borrowers and are not falling over themselves to help resolve the primary dealership problem.

"We treat the banks like a supermarket, effectively," says Guy Dunham, global head of fixed income at HSBC Global Asset Management. "We expect to be able to walk in when we want, to buy what we want, and for it to be on the shelf, ready for us to take away. The problem that [the banks] are facing is stacking the shelves and actually running that inventory."

"We’re in a very, very fortunate position at the moment," agrees David Lloyd, head of head of institutional portfolio management in fixed income at M&G Investments. "We’re sitting there with most of the cards and we do not even have to play a hand. We can sit on the sidelines."

But that is not a situation that can carry on forever, say the banks. "There is always focus on the costs between the issuers and the dealers," says Clarke. "It is the investor-side that is difficult to monetise though. Investors can get away with rotating dealers and burning them for only so long."

If banks can no longer use their balance sheet to pile the shelves high with inventory then perhaps a more direct engagement with investors will resolve some of the supply and demand inequalities that are causing so much pain on the sell side of the market.

"It’s healthy if investors become more closely engaged in the auction events," says Cumbes. "At the moment, the auctions can often be an event for dealers and issuers, with investors following on later."

Responding to demand

How to bring about that increased engagement is another matter, however. The UK is one borrower that market participants say does manage to involve its investors and its dealers, the Gilt-Edged Market Makers (GEMMs) with great success. This was clear in the autumn when, as European markets looked at times as if they were close to collapse, the UK brought blockbusting syndication after blockbusting syndication.

First came a £4.5bn 2052 conventional in September which attracted £8.5bn of orders. That was followed around a month later by a £4.5bn linker which, despite an ultra-long maturity of 2062, printed with a coupon of just 0.375%. Then in November, the UK attracted a £10bn book in an hour to price a £3.5bn 2029 linker through its outstanding curve.

At the end of November, when the UK announced two new auctions to meet an increased Gilt sales requirement, the UK Debt Management Office first announced that it would consult which Gilt to tap before announcing the bond.

Bankers have consistently praised the UK DMO’s level of communication and consultation.

But the UK’s situation may be hard to replicate elsewhere, particularly in the Eurozone. The UK has a large domestic investor base of pension and insurance funds to supply it with the large amounts of cash it needs each year with both sides benefitting from the desire for long-dated paper.

European countries in particular have higher proportions of international bondholders and cannot match the UK’s duration profile. In short, there are more investors in more locations and so the variety of demand and the difficulty of gathering information on what that demand might be becomes a trickier proposition.

"Debt management offices will benefit from staying close to the major dealers in months ahead," says Cumbes. "Many agree with the principle. We all have to make an effort, often in very busy times and act quickly on good ideas."

Moreover, banks looking for market share with issuers and investors will always compete on price to provide the most aggressive service to clients.

Price equilibrium

As such, it might well be those as of now unequal forces of supply and demand that correct market imbalances in time. Banks will eventually be forced to stop overbidding at auctions because they simply won’t be affordable to do so anymore. Similarly there will come a time when investors are no longer able to pick-off dealers for cost-free dealing once banks reach more comfortable levels of inventory.

"The competitive landscape around auction bidding will change and we expect that this will reduce the sunk cost on the dealers," says RBS’s Clarke. "The primary dealership market conditions will change naturally up to a point. Banks will worry less about market share, there will be less over-bidding and costs will fall for all the banks. Balance sheets will be analysed in terms of the opportunity cost of using that capital in the sovereign bond business."


Keeping liquidity liquid

  Once bond yields have started to spike, European leaders have been quick to dismiss the problem as merely one of liquidity rather than one of solvency.

However, liquidity problems can swiftly become solvency problems as investors increasingly fear getting into positions that they will not be able to get out of again and lending to governments dries up.

MTS, involved in five primary markets and 17 interdealer markets overall among European sovereigns, is planning to combat problems of liquidity in volatility-ravaged government bonds with technology.

It has built a system that allows primary dealers to trade with banks in the interdealer market. Those dealers then have electronic access to end investors though an established MTS service, BondVision.

The BondVision platform connects institutional investors to the interdealer market, one of the largest networks of liquidity providers on an online trading platform for euro-denominated securities.

In addition to these markets MTS offers benchmark fixed income indices and market data and continues to develop and launch new products and services to improve liquidity in the market overall. These include MidPrice, a feature designed to attract natural liquidity from the OTC market that allows a user’s trade size and whether he is a buyer or a seller to be kept off-screen ahead of trading.    
  • 13 Dec 2011

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