Clifford Dammers, secretary general of the International Primary Market Association, argues that despite many successes, the international capital markets face some tough challenges in the next few years.
What will be needed are a touch of realism about risk and rewards; a firm hand with the regulators; and, above all, integrity.
The international capital market have enjoyed an amazing period of growth in the debt, equity and money markets. This growth appears set to continue for the foreseeable future.
The major drivers include the introduction of the euro, large budget deficits incurred by most of the member states of the European Union, and the shift by corporate borrowers from own funds and bank credit financing to equity, bonds and commercial paper.
The shift, of course, is the result of a maturing market in Europe and the increasing reluctance of banks to lend at today?s low margins.
Derivatives make it possible for issuers to access different markets and end up with funds in their desired currencies and maturities. In addition, new financial products are developed at a bewildering rate, enabling investors and borrowers to transfer risk and better meet their specific requirements.
Two of the most recent examples are equity default swaps and income depositary securities.
EU sovereigns are turning to underwritten international offerings and expanding the range of bonds they issue. For example, the Federal Republic of Germany announced at the beginning of June that it would issue Eu10bn of inflation-linked bonds a year, as well as foreign currency bonds, probably using a syndicated structure.
A credit market requires different standards
The market is looking forward to these glittering opportunities, but should realise that challenges and difficult issues lurk among them.
The rise of a credit market has occurred in an environment of low nominal interest rates, which followed a long period of high interest rates. Yet investors continue to search for high yielding fixed income investments.
The results have been, first, products which offer an optical high yield but expose the investor to risks from embedded derivatives and, second, investor desire for riskier assets like high yield bonds, mandatory convertibles and emerging market bonds such as those issued by Argentina.
One hopes that in the long run investors will become more realistic about their yield expectations (assuming inflation remains under control) and that in the short run they will be satisfied as interest rates rise, at least in dollars and sterling.
However, it is discouraging to see a recent study reveal that the average American believes 10% is the normal interest rate for low risk investments.
Eurobonds grew up as a market for supranational and sovereign issuers and banks, at a time when most banks which were regular issuers were rated double-A or triple-A. As we move into a credit market, issuers, intermediaries, investors and regulators must change their ways of doing business to reflect the new reality.
Simple documentation, light prospectus reviewing and cursory due diligence may have been appropriate for issuers like the World Bank and GE Capital but are not sufficient for a triple-B company, no matter how much of a household name it may be.
Investors and intermediaries must acquire credit skills and build up credit departments.
Most important, and more difficult, is that everyone must change his or her mindset to reflect the new environment.
Issuers have the whip hand
Much of the behaviour in the fixed income market in Europe is due to the imbalance between issuers and investors. The scarce resource in Europe is issuers, and this will only come into balance with the number of investors when many more issuers turn to the capital markets.
The imbalance leads investment banks and their lawyers to cede documentation and business points to issuers when deals are negotiated.
Investors such as the Gang of 26, who issued a statement last October calling for more stringent standards object to the absence of covenants or to the misleading nature of the few residual covenants that still exist in bond issues ? but they have not been able to change market practice.
If an investor were to refuse to purchase bonds whose terms it disliked, in today?s market it would find a long queue of other investors eager to take its place. Even to ask for the prospectus and spend a few hours studying it risks the issue being sold out and the investor missing any allocation of paper.
Investors were recently able to solve the structural subordination problem in the European high yield sector, but this was only possible because the limited number of investors in Europe who were purchasing high yield bonds were able to organise a boycott of the deals they thought were incorrectly structured.
As more investors have started to buy high yield bonds one hears that the line on structural subordination is not holding.
Fending off regulatory over-reaction
All of this would have been true whether or not we had endured the corporate scandals of Enron, Parmalat, Ahold and Cirio ? but these scandals, and the weaknesses they exposed, highlight the challenge and, unfortunately, frequently lead to a kneejerk over-reaction by politicians and regulators.
Financial intermediaries and issuers around the world face an ever-increasing regulatory burden. Europe sometimes seems to be leading the way and many participants fear a kind of leapfrog among legislators and regulators, where a regulatory initiative on one side of the Atlantic provokes a response on the other which goes beyond what the first legislator or regulator did.
Recent examples are the UK Financial Services Authority?s CP 205, which went well beyond the global settlement in New York on regulating conflicts of interest in the research function, and the EU?s proposed 8th Company Law Directive, which is largely modelled on the Sarbanes-Oxley Act.
Understanding and complying with the regulations is a challenge in itself. Market participants must recruit and train compliance personnel and give them the power and status to do their jobs effectively; and compliance officers must give robust advice to their firms. All employees must become compliance aware.
This is a real challenge when the tradition of the Eurobond market is as an offshore market and bankers who were trained in domestic markets must be sensitised to cross-border compliance issues.
Regulators must find a way to write regulations which are clear and make sense; the best regulations go with the grain of the business and not against it.
Brussels law-making needs to improve
The regulatory system in Europe is increasingly driven by the European Union. Most new regulation in the capital markets field is produced in Brussels.
Unfortunately, the quality of that legislation leaves a lot to be desired, both from a technical drafting point of view and from a pure policy perspective.
Although some of the most recent legislation produced by the European Commission is much better than in the past, the problem of poor drafting is exacerbated by a Commission decision on how to introduce regulations under the Lamfalussy process, which aims for more efficient adoption of financial services legislation on the road to a single market for financial services.
While the main framework laws must be passed by the European Parliament as primary legislation, ?level 2? implementing regulations, including measures to react quickly to market changes, were designed to be enacted without primary legislation.
Unfortunately, the Commission has decided that level 2 provisions will be issued as regulations, which are directly applicable, instead of directives, which have to be implemented by national law and therefore leave scope for national legislators to tidy up infelicitous drafting.
So far the market has been unable to find a way to ensure a proper review of Commission proposals by the European Parliament and the European Securities Committee.
The Commission must improve the quality of its output and the market, through individual firms and the national and international trade associations, must engage earlier and more effectively with the Commission and the member states to influence legislative proposals.
A major challenge for the EU as it legislates for a single, integrated financial market for Europe is to find a balance between promoting a so-called safe market in Europe and retaining the attractiveness of the European market for non-EU issuers, who make up almost two-thirds of the new and outstanding issuers.
Market infrastructure and laws need updating
It is not only the practices and mindsets of the market participants that must change as Europe moves to a single market for financial services. Much of the infrastructure must be modified to accommodate the new market: tax and permitted investment laws, clearing and settlement infrastructure and consolidation of stock exchanges and multilateral trading platforms.
The legal background must also be brought up to date to reflect the fact that bank credit is rapidly becoming less important as a source of funding.
Most European insolvency laws favour banks and ignore or give a very minor role to bondholders. The new proposals for restructuring laws in France and Italy will perpetuate this bias if they are not amended in the legislative process in the next few months.
Accounting standards in most EU countries were designed to provide information for bank lenders, not outside shareholders and bondholders.
We need good laws providing for netting, including cross-product netting, and repurchase agreements. The Hague Convention on securities held through an intermediary must be ratified as soon as possible and it is good to see that the EU is amending three existing directives in order to conform to the Convention.
The market has already responded to the legal and documentary challenges posed by massive volumes of transactions by agreeing standard documentation and master agreements. This effort must be continued and accelerated and the public sector should encourage this rather than resisting it.
We do not need a repeat of Europe?s decision to allow each national central bank and the ECB to develop and use its own different repurchase agreement when the industry had already agreed on and was using a standard form.
The industry, for its part, should not support two private sector forms merely to satisfy an unnecessary conflict between the civil law and common law families.
Experts, including the Giovannini Group of private sector practitioners advising the EC, have called for a securities law for Europe, to provide legal certainty for cross-border transactions.
Staying on the straight and narrow
Unfortunately for the intermediaries, increased volumes do not necessarily mean increased margins. As the international capital markets have grown, fees and spreads in almost all products have shrunk. One of the biggest challenges is how to maintain profitability in an environment of shrinking fees and increased compliance costs.
Many banks have responded by emphasising higher value added products which can support higher fees; others are employing the firm?s capital in proprietary trading and block trades. This has been a major cause in the drive to create new products.
What intermediaries must not be tempted to do is take advantage of asymmetries of information to abuse clients; engage in a race to the bottom in cutting corners on things like due diligence and documentation; or lend themselves to highly questionable transactions for which there is no legitimate business justification.