Dealers’ choice

In January, Credit Agricole exited primary dealerships in Austria and Ireland and for bills in the Netherlands, following in the footsteps of similar moves by rival firms such as UBS and Credit Suisse, which have also beaten a retreat. The French bank joined Royal Bank of Canada and compatriot Societe Generale, which have both given up primary dealerships in the UK in recent years.

There has been a steady reduction of the number of primary dealers participating in European government bond markets over the last decade. In 2016, there were an average of 18.5 primary dealers by country, compared with 23.2 at the end of 2006, according to a report by the Association for Financial Markets in Europe (AFME). In the last two years, AFME said the number of primary dealers has also decreased in nine of the 16 jurisdictions.

Primary dealers remain an integral part of government bond markets, buying new issues at auctions to meet demand from investors and to maintain secondary trading liquidity. Without their support, countries would find it harder to sell debt, forcing them to offer investors higher interest rates.

The blunt instrument of regulation is driving the reappraisal, and the introduction of measures such as the leverage ratio fails to discriminate between assets of differing risk. While government bonds carry a zero risk-weighting, the leverage ratio measures banks on returns, so the balance sheet they used to allocate now has a cost. The decision by these banks to withdraw is part of an overall appraisal of their trading operations brought on by the need for banks to cover their cost of capital.

The flight from primary dealerships is more nuanced than it appears and relates to banks’ broader strategic appraisal of the profitability of their fixed income business bv country and product. Rather than signalling the death knell of the dealership model per se – there is, after all, no alternative to it other than syndication – incumbent providers are picking the spots where they want to compete.

“The banks that have left the market are peripheral players, we have not seen a major player reduce its offering. In truth, there has always been some degree of churn, as issuers operate a promotion and relegation system,” said Zoeb Sachee, head of euro government and SSA trading at Citigroup.

Core business

Primary dealerships require significant commitment, and for fixed income houses they continue to form a cornerstone of the fixed income business. Bankers say there is a core of markets in the eurozone – France, Germany, Italy and Spain – where fixed income players with serious aspirations will maintain a presence. While it has pulled back from some markets, Credit Agricole continues to operate in that quartet of markets as part of its eight European dealerships.

Given the commitment required and the price associated with bidding in auctions, banks must have scale in the markets they have chosen to compete in.

Citigroup is one of the firms that remains committed to primary dealerships across the board and has increased investment in its sovereign business since the crisis. Given the level of commitment and investment that is required, it is no surprise that the business favours long-established players who say the backdrop is improving.

“The economics of primary dealerships have altered,” said Sachee. ”Previously, there were stronger and more direct linkages to other businesses: for example, sovereigns were more active in the derivatives market. The regulatory environment has created a more level playing field in terms of required returns on assets. Returns on sovereign businesses may vary year after year but our strategy remains to be a top provider of liquidity.”

Rather than seeing primary dealerships as a cost centre in isolation, leading players such as Barclays and Citigroup regard them as essential tools to remain in the flow and serve their biggest and most important clients, both from an issuer and investor perspective.

“Governments are incredibly important and strategic issuers, with significant funding programmes. For Barclays, public sector has accounted for around half of the new issue bond business we are involved in for EMEA. We have always had a strong focus on participating in primary dealerships because they are an essential part of the market,” said Lee Cumbes, head of SSA origination for EMEA at Barclays in London, which holds 16 primary dealerships across Europe.

The more primary dealers take in allocations, the higher they are rated by sovereign debt agencies, which becomes a virtuous circle.

Along with the obligations, there are benefits. For example, primary dealers can win syndicated business and also benefit from incentives.

“The more PDs bid for allocations at auction, the more they can benefit from the option offered by many issuers to buy bonds at average price up to two business days after the auction is priced. So, if the market rallies, they can benefit,” said Sachee.

Also, serving as an authorised dealer puts banks in a strong position to act in a broader advisory capacity to a government.

Electronic competition

The rise of electronic trading is also acting as a catalyst for some players to pull back from the market. This is redrawing the landscape in favour of a small group of high-volume players.

“Banks have had to invest in pre and post-trade infrastructure that creates economies of scale‎,” said Sachee

Those banks that have retained their coverage have developed their offering in line with developments in technology, enabling them to cut costs and boost efficiency.

“Because of the measures we took in 2014, we have driven much greater efficiencies across the business and ensure we are getting the right returns. Our sales and trading and origination are fully aligned to serve investors and issuers alike,” said Cumbes.

But as well as incumbent players increasing their grip on the market, there are also signs of new entrants. Danske Bank, which is unencumbered by balance sheet problems, gained primary dealer status in Spain last year.

Some banks have also been put off by the lack of liquidity in the market, a situation that has been made worse by the European Central Bank’s bond-buying programme. The ECB is a buy-and-hold investor that has hoovered up a large part of the market, deterring more traditional investors who otherwise would churn their portfolios more regularly.

”The ECB is a forced buyer which does not make decisions based on fundamentals, and that has discouraged some investors who don’t want to buy in an inefficient market,” said one banker. ”This makes primary dealers the lenders of last resort.”

Markets have become less liquid because of a reduction in the allocation of balance sheets, a development that comes as a result of the Volcker Rule, the part of the Dodd–Frank Wall Street Reform and Consumer Protection Act that prohibits banks from conducting certain investment activities with their own accounts.

It is not capital charges that have sapped liquidity, more the end of proprietary trading, which one banker estimates has reduced the amount of balance sheet capital deployed by 60%–80%.

There are signs that debt management offices are starting to respond to the shifting market dynamics.

“We are seeing evidence of DMOs trying to offer more revenues, and conducting syndications more frequently,” said one head of SSA origination.

Some DMOs in less liquid markets may also reduce the amount of bidding at auctions.

“It’s in the interest of DMOs to have over-bidding in order to reduce the yield, but there is a growing recognition that too much over-bidding could hurt the market,” said the origination head.