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Bond markets aren’t orderly, but they aren’t rigged

Nemat Shafik Bank of England
By Owen Sanderson
17 Jun 2014

Last week, the UK government, fired up with the success of the Banking Standards Review, the Independent Commission on Banking, the interest rate swap misselling review, the payment protection insurance review, and the Royal Bank of Scotland restructuring group review, and delighted with the progress of the Co-op review, the review of foreign bank branch capital holdings, the review on variable bank leverage ratios and the review of stress testing proposals, decided to launch another financial markets review.

This time, the topic was chosen with the 2015 election firmly in sight — it will cover benchmark abuse.

The absence of any evidence of actual harm to the public from Libor, FX and precious metal manipulation has not dampened public appetite for bankers' blood. Certain desks in certain banks have been caught red handed, engaged in behaviour which doesn’t stand up once exposed to scrutiny.

But the new review doesn’t just stop at the markets where abuses have been found. It takes in the bond market too. So far, the only grubbiness that the FCA has been able to come up with was Mark Stevenson of Credit Suisse, the Gilts trader who intentionally pushed up Gilt prices ahead of a QE round.

One might argue that pushing up prices ahead of a giant, price-insensitive buyer entering the market is exactly what a trader should be doing. Or that the literal point of QE is to raise Gilt prices. Or that Stevenson got his comeuppance when the Bank declined to buy the manipulated Gilt in size, leaving Stevenson long at levels well above market.

But the new review brings in bond trading anyway. The Treasury, which is co-managing the review with the Bank of England and the Financial Conduct Authority, said: “the review will focus on those wholesale markets, both regulated and unregulated, where most of the recent concerns about misconduct have arisen: fixed income, currency and commodity markets, including associated derivatives and benchmarks.”

In cash bonds, distinct from money markets, FX, or precious metals, there is nothing to rig. Illiquid issues can be cornered; banks with good intelligence can have an advantage and big orders, as in any other market, can be front run.

But across most of the bond market, there is no decisive benchmark to be knocked down or corrupted, no fixing process that can be fixed by a determined group.

These benchmarks create incentives for collusion and an easy way to make it happen. Once large volumes of transactions reference a single, fictional number, derived under abstract, off-market circumstances, there is means and motive in place for institutions or staff to manipulate the number.

By all means reform these benchmarks (and ideally, replace them with market derived numbers). But leave bond markets out of it. As the review itself acknowledges, traders already have to grapple with adapting their business to multiple new regulations.

Once the EU's Markets in Financial Instruments Directive comes into force, the OTC bond markets are will be in for a shock, with transparency in pre- and post- trade spheres set to shake up existing businesses, while bank capital rules have left dealers with tiny inventories and minimal risk appetite. The last thing the bond market needs is another review.

By Owen Sanderson
17 Jun 2014