Tuesday, 22 January 2019

Burden of abundance

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Liquidity in the bond market is becoming increasingly difficult to find and there are no easy solutions to the conundrum as ever-tighter banking regulations push lenders to raise their levels of risk-weighted assets.

In Coleridge’s Rime of the Ancient Mariner, a group of shipwrecked sailors are left isolated and idled far from shore and wracked with thirst. Wherever they look they see water – yet they cannot drink a single salty drop of it.

Debt bankers, investors, issuers, and even financial regulators, must know the feeling. For these days, debt is everywhere, clogging up the machinery and lying stagnant in deep, illiquid pools. In every typical month more is issued than is redeemed, while less, as a share of the entire universe of active debt securities, is actively traded.

The world is literally swimming in debt, yet ever fewer funds, lenders, and investors actively see value in the simple process of buying, holding, and trading the stuff. Why is this – and more to the point, do any solutions to the market’s malaise exist?

A few short years ago, market-making and proprietary trading worked together in reasonably sweet harmony. They acted like shock absorbers, smoothing price volatility, driving liquidity flows through the secondary markets, and instilling confidence in primary issuers. That confidence, and that liquidity, is now gone.

Most financial institutions simply cannot hold as much debt as they once did. Lenders in Europe and beyond are under increasing pressure from any number of regulators to boost their levels of risk-weighted assets, and to hold fewer liabilities on their books. Since 2008, the inventories of US corporate bonds held by broker-dealer banks has plunged to US$50bn from US$300bn, according to research from CQS International.

“With regulators asking banks and broker-dealers to create ever larger capital buffers, inventories have been going down, despite there being so much debt around in the world,” said Jerome Legras, head of research at Paris-based Axiom Alternative Investments.

This is not a new phenomenon. Liquidity has long been a pressing issue for bond traders, investors and issuers. In part, this stems, as so much does, from the events of late 2008.

Deep mismatches

“The financial crisis deeply changed the way that market-making works,” said Eric Cherpion, global head of DCM syndicate at Societe Generale. “It created deep liquidity mismatches. And either due to risk management, or due to new or rising capital constraints, banks have less gunpowder at their disposal, so they need to be doubly convinced that they are stepping into the market, or into a debt security, at the right level.”

That in turn creates a clear mismatch, notes Axiom’s Legras, between what brokers can sell, and what traders can manage.

“Liquidity,” he said, “is becoming increasingly hard to find. It’s especially hard for major funds that manage hundreds of billions of dollars’ worth of bonds, and that may need to sell a few hundred million dollars’ worth of bonds in a day. That presents a challenge.”

As everyone is by now painfully aware, there are no simple answers to this conundrum. Rather, there are an awful lot of unpalatable solutions (some of which contradict other well-meaning solutions), and an even larger measure of unanswered questions, all of which pervade the thinking of regulators and traders constantly waiting for the next systemic crisis or flash crash.

The latest market spasm occurred in early May, when volatility in 10-year US Treasury yields hit levels not since last October.

“You have a banking community with less and less balance sheet to deploy. The waning levels of liquidity out there, and the waning ability of the market to absorb shocks, merely exacerbate the threat of volatility”

There were differences between the two events. Last autumn’s so-called flash-crash was stoked by traders betting that US interest rates would stay low. This year’s bond rout, which briefly caused recalibrations of European sovereign debt, put a rocket under yields in US and German 10-year debt, forcing the market to judder and spasm.

Seeking culpability, traders returned to the source, blaming the market’s dearth of liquidity. This, of course, makes sense. If a security of any type has a willing seller but no willing buyers, one could argue against it having an intrinsic value.

“You have a banking community with less and less balance sheet to deploy,” said Charlie Diebel, head of rates strategy at Aviva Investors. “The waning levels of liquidity out there, and the waning ability of the market to absorb shocks, merely exacerbate the threat of volatility.”


To many, the bond market’s woes are self-fulfilling. Volatility, the argument goes, begets volatility: the more there is of it, the greater the threat both to the bond market and to the wider financial economy.

“Everyone is nervous and jumpy, and no one holds the same position for very long,” notes Aviva Investors’ Diebel. “That fact, combined with a lack of prop trading, and a general shrinking in balance sheets that were once put to work on the sell-side, is working to make markets very skittish.”

Moreover, analysts and investors warn, these problems aren’t going away – and volatility is here to stay. “The jitters we’ve seen lately in terms of price action is a feature we’re stuck with,” said a leading London-based DCM banker.

If that is really the case, everyone should be looking first to identify and define the problem, then to seek clear and coherent solutions.

To many, two clear threats exist: a surfeit of regulations, and a lack of balance sheet on the sell-side. These problems also appear linked, with the former leading directly to the latter. Ease off on the rules (while continuing to force financial institutions to be more responsible for their own actions) and the liquidity will return, the thinking goes.

Finding the right curve

Everyone from regulators to traders, investors to corporate treasurers, politicians to career bureaucrats, knows the bond market is ailing. The challenge lies in finding the right cure. Even here, arguments rage over how to form and foster liquidity, then to put it to work in the right ways. But how to achieve that?

At one level, European officials are painfully aware of the need to create a much deeper and far more liquid US-style market for debt securities. For years, lenders have been slowly shedding their holdings of bonds, particularly the higher-yielding variety.

“Reducing commercial banks’ share of corporate debt as a whole, and creating multiple points of entry for corporates into the markets, rather than solely via the banks, is a desirable objective,” said Etay Katz, a partner at Allen & Overy in London, who specialises in the impact of regulations on financial services providers.

“It’s healthy from the perspectives of competition and bank deleveraging, and in terms of the evolution of the investor base, so all the arrows should be pointing in that direction.”

Many hope that Europe’s proposed capital markets union, designed expressly to beef up non-bank finance, will boost liquidity, reduce volatility and cut financing costs, while further integrating the region’s capital markets.

Yet at the same time, Europe is stymieing its own ambition. Unsure whether to give freer rein to the region’s capital markets, EU officials continue to err on the side of caution. In March, the European Banking Authority launched a public consultation with the aim of seeking stricter limits on the exposure of regional banks to any shadow banking entity.

To a large slice of the watching public, burned by financial crisis and bank bailouts, this seems fair and reasonable. Why permit banks to shoulder yet more risk, simply to theoretically boost the liquidity of a financial instrument they may only vaguely understand.

“On the one hand, you have policy objectives designed to widen and deepen Europe’s bond markets. On the other, there are rules being proposed that would reduce bond trading, and force banks and non-banks to retrench further”

Yet in so doing, the EBA is pre-emptively negating the positive impact that non-bank investors – dedicated bond funds, for example – would have on the wheezing debt markets.

“If we are saying that banks cannot have significant funding or trading relationships with a majority of non-regulated institutions such as funds, which are also the largest prospective investors, how on earth is Europe ever going to create a true, deep bond market,” said Katz.

“On the one hand, you have policy objectives designed to widen and deepen Europe’s bond markets,” he said. “On the other, there are rules being proposed that would reduce bond trading, and force banks and non-banks to retrench further.

“So you have forces pulling us in opposite directions, which is counter-intuitive to the aims and ambitions of the capital markets union, and which threatens to further sap liquidity from the market.”

The challenges, then, remain as great as ever, particularly in fretful, jittery, cautious, protectionist old Europe, with its contradictory rules and its disinclination to act decisively.

So long as the region is burdened by politicians and regulators torn between fostering a truly liquid, investor-driven debt market and the desire always to protect the little guy, the region will remain awash with untradable, uncoveted, untouchable debt, clogging up the machinery and lying stagnant in deep, illiquid pools.

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