Brett Chappell, Head of Fixed Income Trading at Nordea Investment Management examines the changing dynamic of European fixed income, and how the answers may not be as simple as they first seem.
Liquidity is making the rounds as the top buzz-word of 2015 in the fixed income universe. Everyone bemoans the lack of it, and points to the heady days of a decade ago when it was abundant. In the run up to the crisis, there was in fact a liquidity bubble, one which led to a somewhat overzealous use of balance sheet by certain market players. When RBS filed its 6-K with the SEC on August 3rd, 2007 it stated “Total assets were £1,011.3 billion at June 30 2007.” To put that in perspective, this roughly equates to the 2007 annual GDP of the Republic of Italy.
Today things are very different, and the pressures being exerted on the flow of secondary market trading have reached boiling point. In certain asset classes, such as European Credit Bonds, it is becoming close to impossible to move wholesale sizes in the market without causing a ruckus. Banks are being told to swim with handcuffs on – the regulation is both onerous and in certain cases contradictory. A deluge of acronyms: COFIA, CRD IV, CRR, CVA, etc. is causing alphabet soup-induced indigestion among front office and compliance personnel alike.
It is abundantly clear that banks are displaying greater reticence in using their balance sheets in providing two-way liquidity to the market. The cost of capital is at a premium, and many banks’ market operations are reevaluating their business models. Is it economically viable to allocate resources and balance sheet to this business? Bank trading desks are changing their modus operandi from a principal-based to agency-based approach. “We can work an order for you…” is a rather clichéd response we receive on many queries when we seek to move any size superior to 5 million EUR in the market.
Transparency Liquidity
ESMA (the European Securities and Markets Authority) issued a behemoth of a consultation paper concerning MiFID II on December 19th, 2014 http://www.esma.europa.eu/system/files/2014-1570_cp_mifid_ii.pdf , which asks participants to revert with their input before March 2nd, 2015. There is a very small window for stakeholders to read, analyse, and formulate a coherent response.
- Two topics which the technical paper discusses in depth are the definitions of instrument liquidity and transparency. The latter is not a solution to the former.
- Moreover, superimposing an equity market template on a fixed income market which has more granular and diversified maturity profiles would make no sense.
The United States introduced TRACE in the United States in the 00’s in an effort to increase transparency in the bond market. The OTC European bond market is less deep and more heterogeneous than that of the United States. There seems to be a current mood to introduce an even stricter transparency regime in Europe in both the pre- and post-trade levels. Transparency in and by itself sounds like a good thing, however the application of it may have a detrimental effect on a smooth functioning of the European financial system.
If a bank must make “professional counterparty” prices available prior to trading a given security, then chances are that the market-makers’ bid-offer spread will widen.
Post-trade reporting will open the door for faster-moving hedge funds and less scrupulous brokers to effectively front-run the interest of a larger asset manager who is incrementally attempting to take-on or off-load a wholesale position. Deferral times should be sufficiently long for market-makers to square positions, otherwise they may find themselves unwilling to provide markets in given bonds. ESMA is proposing to set up standards for a liquidity classification on an ISIN by ISIN basis per instrument (covered, credit, etc.) with classifications such as SSTI (Specfic Size to the Instrument) and LIS (Large in Scale). Deferral rules and waivers will apply on an individual basis.
Experience shows, especially in times of market stress, that the European corporate bond market is by its very nature illiquid. Some insurers, for example, with very specific accounting rules in place, will buy a well-rated benchmark bond and hold it for an extended period of time. In an ideal situation with no major swings in investment strategy or issue ratings, this bond will be held until maturity or at least the point when it reaches a short enough tenor to be reclassified and sold off to money market portfolios. CSDR (central securities depositories and securities settlement regulation) legislation in the EU will introduce forced buy-ins, which may reduce banks’ willingness to provide offers in a market where the bonds are simply squeezed in the repo and difficult to procure. Market-makers may have to reevaluate their willingness to provide two-way prices in the bond markets.
Dude, where’s my liquidity?
We at Nordea Investment Management wish to have as many viable trading counterparties as possible for access to greater liquidity. We speak to bulge-bracket and niche players who endeavour to provide us with good research, prices, and liquidity when we need it. To this effect we must ensure that our counterparties are solid entities on whom we should rely. The KYC process is very thorough, as it is important that we deliver the best returns to our clients whether they are retail or institutional investors.
Trading
Most outstanding European debt is no longer on the traders’ books, and the bottleneck to access the market in RFQ format is currently dysfunctional. Many initiatives are underway for various trading platforms to enter the fray to challenge incumbents Bloomberg, MarketAxess and Tradeweb. The technology is there, and MiFID II requirements can be programmed in. The three majors are all introducing more developed platforms along with nimble entrants who can tailor-make solutions to the needs of 2015. Examples of the latter include Algomi, BondCube, TradingScreen and Liquidnet. These new solutions are meant to supplement, not replace, existing relationships with sell-side counterparties.
Inventory
Technical projects further upstream from trade execution, such as Project Neptune, will create the nuts-and-bolts of pre-order delivery of bank inventory to the buy-side through a FIX API standard. This is supplemented by receiving Excel spreadsheets from brokers, on-line services such as B2Scan, and pure data mining on Bloomberg.
It’s NOT equity
When financial laymen ask what I do, and I reply finance, I usually receive hostile stares. Often people will ask me what stocks to buy but I have to come clean and tell them I work with bonds. Explaining debt maturity profiles, coverage ratios and Basel III capital requirements is a sure-fire way to kill a dinner party. The equity market is easier to grasp – there are one or two instruments to choose from in general, not in some cases several hundred ISIN codes from which to choose. Dealing in debt requires great patience as the general illiquidity of the instruments makes it very difficult to trade at levels seen on screen. A typical European Bloomberg ALLQ is simply a two-way indication of 1 million x 1 million EUR. Our experience shows that circa 50% of the time, the prices are purely indications, and even small queries to the tune of 250,000 EUR can lead to a bank pulling back its offer by 15 cents in an investment grade bond. When the size tends to be larger, say in excess of 10 million EUR, we on the trading desk have to very carefully consider how, where, whom and when to best to approach the market lest we sweep the rug right out from under us.
L’UNION FAIT LA FORCE / EENDRACHT MAAKT MACHT
The drivers for this European innovation seem to be based at the termini of the Eurostar: Paris and London. However, the asset management community is of course spread out throughout Europe from Lisbon to Helsinki. These players are in constant dialogue with the local regulator, but need to be aware of the changes afoot and to openly discuss the matters at hand. The changing landscape will have very large consequences for the asset management community. Since many European banks are becoming less willing to lend to the real economy due to capital restraints, it is the investor community, which is now in the driver’s seat providing funding for companies, infrastructure, and other projects that promote growth and employment.
European Commission President, Jean-Claude Juncker has proclaimed his support for a Capital Markets Union http://ec.europa.eu/priorities/docs/pg_en.pdf This is a lofty goal, but the devil is in the details. It is of paramount importance that ESMA gets this right. Finance is already the most regulated industry in Europe. Decisions taken in the coming months will have a resounding effect on the business and repercussions beyond the trading floors.
Ultimately it becomes a question of how end-investors can efficiently provide financing for the firms that make up the real economy. The approach must ideally be backed by both a broad representation of buy-side and sell-side to put forward as much as a common front as possible given what is at stake. Unity makes strength, and it is important that the rules are set right from the beginning. It’s not just good for the clients’ investments at risk, but Europe as a whole.
