The dealers' dilemma

European governments have coped admirably with their hefty funding programmes in the crisis years, but there are alarming signs that the primary dealers that have eased this process may be struggling to keep their businesses viable.

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Sovereign debt managers in Europe have been given the task to raise €1.76trn this year, a level that has fallen from its 2009 highs, although it still stands some €638bn above 2007 volumes.

Unfortunately the debt pile is not falling fast enough to silence concerns that a heady mix of capital constraints and risk aversion is taking its toll on banks’ trading desks, stifling one of the biggest investor bases in government bonds.

Moreover, debt managers are well aware that other regulatory challenges lie ahead, and in a recent survey conducted by the OECD, 15 European governments expressed concerns that forthcoming regulations like Basel III (CRD IV) and the Volcker Rule could seriously hamper the willingness and ability of their primary dealers to provide liquidity in sovereign bond markets.

This is likely to impact on funding costs at time when “austerity”, “cutbacks” and “savings” are the only policy-speak in Europe.

“If banks have to put more capital aside to trade our bonds, then it will obviously have a knock-on effect of the pricing levels we can achieve,” said Erik Wilders, the head of the Dutch State Treasury Agency.

Dealers have subsidised euro sovereign markets by some tens of millions of euros in recent years, said market sources, while across the community the annual spend could easily run up to around €500m.

Fee-paying syndications did little to cover the losses, but dealers justified their action by the kudos it brought for the bank and the ancillary work it generated in corporate and financial sectors.

But banks say these subsidies have become increasingly hard to justify, especially with the prevailing market conditions making it increasingly difficult for them to otherwise turn a profit.

Negligible returns

The biggest problem is the low-yield environment, which has prompted a decline in real money being invested into European government bond markets and ramped up the pressure on dealers to provide the backstop liquidity.

“Dealers have to be there come rain or shine and, when times are bad, debt managers inevitably lean on their dealers,” said one syndicate official.

While many of the best rated sovereigns benefit from occasional bouts of flight to quality, negligible – and in some cases negative – returns are starting to wear on even the most risk-averse investors.

Around two-thirds of respondents to an RBS survey of 60 central banks in April said they were more inclined to invest in equities than a year ago. When it came to government bonds, 70% said they now preferred Single A rated bonds, with only 25% showing a preference for the Triple A names they were once so attached to. The central banks in question had combined reserves of US$6.7trn.

In Europe, only Estonia, Malta, Poland, Slovakia and Slovenia fit the Single A criterion, all of which have much smaller funding programmes than the Western economies of France, Germany, Italy, Spain and the UK.

A similar survey of 155 institutional investors by Allianz late last year showed other key real-money investors were also losing interest.

Nearly 70% considered corporate bonds a reliable alternative to sovereigns, while 37% were happy to substitute their holdings with emerging market debt and 22.7% with covered bonds. Respondents held a combined total in excess of €1.9trn in assets under management.

Lenders of last resort

When real-money interest wanes, primary dealers become the lenders of last resort. Primary dealers are obliged to buy a set percentage of total government bonds, usually around 2%–2.5%, over the course of the year. Holding this inventory can be of some use when it comes to making close prices to clients in secondary markets.

However, origination officials say the auction process, favoured by sovereigns as being the most economical way to fund, is a loss-making proposition from the start because few other investors want to participate in primary markets.

“It is well-known that all auctions are typically loss-making propositions for banks – it’s hard to make a profit from buying bonds that are pricing through secondary curves,” said one head of SSA origination at a London-based investment bank.

The reason dealers remain competitive in this process is to try to win mandates for fee-paying syndications.

“It is very hard to recoup the cash that the top dealers spend on auctions. They need to get on syndications, and they need those syndications to go well,” said the syndicate official.

Unfortunately, they do not always go well.

For example, Austria recently issued a rare dual-tranche 10 and 20-year syndicated bond, in a week when its 10-year yields hit a historic low of 1.46%.

The Austrian Treasury was delighted at locking in these low yields. Unfortunately, the dealers who took down a handsome chunk of those bonds were not so thrilled, especially when they immediately started to widen after pricing.

On the 10-year line, distribution statistics showed 67% of bonds were allocated to banks, a significant portion reported to be the trading desks, as bank treasuries favour short-dated, more liquid assets. On the 20-year, 56% of bonds went to banks.

This is not an anomaly. On the two previous European sovereign syndications from Finland and France, over 30% of allocations went to banks, again reported to be largely primary dealers. Both deals are still trading wide of where they priced.

Sovereigns do not publish distribution statistics for their regular auctions, but sources say dealers regularly take down 80%–90% of the bonds.

Illiquid secondary

As a result of the pressure put on dealers in primary markets, their support of secondary markets is diminishing, another indication of the limits to the capital dealers are willing to put to work.

Investors complain that secondary market liquidity is drying up, especially for the lower rated peripheral countries where market volatility is at its highest.

Of 100 investors that contributed to a survey commissioned by the Association for Financial Markets in Europe earlier this year, 39% felt liquidity in government bond trading had declined over the last two years.

Again, debt managers are well aware of the problems, and in the OECD survey, 11 European countries said they had eased market-quoting obligations for their dealers over the past year, while others modified the ways in which they evaluate dealer performance.

Portugal, for instance, eager to see better functioning two-way secondary flows, decided last year to base 40% of its assessment on the direct contact banks were able to facilitate with investors in conjunction with their ability to quote prices to potential clients, a spokesperson for the debt management agency told IFR.

Some bankers, however, are not convinced this is a problem that will abate any time soon.

“In general, banks are carrying much less inventory because there is less overall appetite for risk, for structural and cyclical reasons,” said Laurent Fransolet, head of European fixed-income strategy at Barclays.

“But it’s a self-fulfilling prophecy: if banks provide less liquidity, then markets can become more volatile.”

Dangerous precedent

Fransolet does not doubt banks’ commitment to the business, only the risks they are prepared to take.

There are others, however, who say the surprise exit of UBS from the sovereign, supranational and agency space late last year has set a dangerous precedent for other banks that may deem the business too capital intensive.

“Look what happened at UBS; there are no sacred cows anymore,” said one head of syndicate at a London-based bank.

“If you trade primary dealerships and you like your job, then you are going do what you can to make it profitable. You are not going to throw your toys out the pram and complain it’s a loss-leader, because management will just shut it down.”

Records from AFME show that in December UBS was still a primary dealer in Austria, Belgium, Germany, France, Greece, Ireland and Italy. Since then, it has left Austria and slipped to the bottom of the league table in France. Sources say it will not be long until it has exited all its dealerships.

The severe UBS approach has not yet been replicated elsewhere, but it has not stopped banks looking across the street at their neighbours and speculating on which other houses may also exit.

The situation faced by UBS was not of an isolated nature and stands as a warning to issuers not to overstretch their counterparts.

UBS’s exit was used as fodder for aggrieved banks to hit back at SSA issuers, specifically supranationals, that they feel are not paying their way in the swaps market. As a result, some have changed tack and others are paying fairer rates. (See “Collateral damage”)

This has not really had a direct effect on sovereign debt managers, as by and large they do not swap, however it is not a great leap to suggest that a similar concerted uprising from dealers over the uneconomical nature of government bond markets could have similar successes given their systemic importance.

“Shrinking balance sheets among the primary dealer community has been masked by the excess liquidity pumped into the system”

So why has this not happened?

It could simply be that bankers are nervous about complaining and thus drawing unwanted attention to their own P&Ls. But, more likely, it may be that while it is increasingly difficult to make money in these markets, at least there is stability.

Masking the problem

The reason for that stability is in essence twofold – the liquidity provided by central banks and bank treasuries.

European Central Bank intervention in the shape of the long-term refinancing operation allowed banks to post government bonds as collateral to the ECB for cheap funding. As a result, the ECB now holds a significant amount of paper, which has in turn helped to stabilise these markets.

From last summer, it extended its remit to buying bonds of struggling countries, which in effect prevents peripheral yields from spiking to untenable levels. This is still untested, but few doubt the ECB’s resolve to do “whatever it takes” to preserve the eurozone.

Elsewhere on the continent, central banks have gone for full-blown quantitative easing. The latest reports from the UK’s Office for National Statistics showed that the Bank of England held £398bn, just shy of 30%, of all UK government bonds.

Bank treasuries, as well, have increased their holdings as they build up liquidity buffers to meet new capital adequacy rules.

“Shrinking balance sheets among the primary dealer community has been masked by the excess liquidity pumped into the system,” said another bank origination head.

Neither of these liquidity sources should be taken for granted, however.

At some point, when central banks are convinced that economies are finally in recovery mode, and that debt levels are going down (and going to stay down), they will put a stop to these policies, or even look to unwind their debt holdings.

“The exit strategy is going to be a big question, and nobody is really addressing it at the moment,” said the second bank origination head.

Bank treasuries may also be forced to scale back demand if sovereign bonds do not remain zero risk-weighted under new regulations.

Equilibrium

If you strip back all the artificial liquidity in government markets, it is quite daunting to see how integral a handful of dealers are to the functioning of these markets. The dilemma for the people running these operations is to weigh up whether they are actually being sufficiently rewarded for their responsibilities and the risks they are taking. With yields at historic lows in many countries, the answer at the moment is probably no.

As central banks have stepped up to replace real money the market has reached a sort of unhealthy equilibrium. It will be some time though before this shifts towards a normalised supply-demand dynamic, with little talk of an exit strategy as yet.

If, and when, central banks do decide to change tack, it will hopefully be well signposted so dealers can mitigate against the risk of a sell-off. Before then, though, many may have already lost interest.