Pfandbriefe Roundtable 2009: Part III
IFR: So what's the liquidity situation in Pfandbriefe compared to other covered bond markets?
Diemer: Well, in the market environment where spreads were continually widening, every trader had restrictions to hold bonds. Now, in an environment where spreads are continually tightening, every trader has restrictions to go short on these bonds. So I think the important development of spread tightening now needs to bring about a situation where spreads for Pfandbriefe return to previous levels of volatility. This calmer environment is the prerequisite for a working secondary market, so as to bring about more confidence amongst traders.
Today we have an absence of hedge funds, of prop traders and to some extent also market makers. They all played an important role in the secondary market in the past. From my perspective they are absent now. They have to be compensated. They have been partially compensated by the ECB programme, but maybe the issuers themselves also need to support the secondary market more than they used to do.
IFR: How can they do that?
Diemer: The simplest thing to support the secondary market is obviously to provide a back stop bid for your own issues. That's something which we have done since we issued Pfandbriefe, and put investors, market makers and intermediaries in a position to hold bonds, since they know they get a back stop bid from the issuer.
We also offer our own bonds in the repo market if we hold them on the asset side, so as to provide bonds for market makers to help them to go short.
IFR: Is that standard practice?
Rosenberger: I think at the height of the crisis we all quoted buyback prices for our own Pfandbriefe, but there was no secondary market because it was a seller only market. What the secondary market really needs is turnover and transparency. I think an electronic trading platform is an important tool that helps with transparency, but the real question is how do we increase the level of turnover again? As indicated by Ted earlier, the reduction of ECB activities in the secondary market could help.
Viteau: I wouldn't be too concerned by the current lack of turnover in the secondary market. To have turnover you need to have balance sheet commitment from the intermediaries. What has been completely lacking in the secondary is the transparency.
Since the primary market has reopened, it is even more important speaking to investors for investors to get an accurate price on the secondary market. They have doubled they amount of banks they contact just to make sure that they get a good price indication.
Everybody here has been working with the various associations, intermediaries, investors, and platforms to try and foster transparency. To date there has been no miracle solution. There have been initiatives, we have seen some prices correlate to some extent, but there has not been a central point of contact where all the transactions could provide some indication of what the price is. One of the biggest challenges at the moment is to display traded prices because they have to be in real time. That is very difficult and could lead to some imbalance. But if there was at least some post trade transparency of what bonds traded at what level, those not at the market every day could see what has happened based on real transactions.
Elling: There is always a point where we disagree! I think investors will have a much higher degree of transparency than banks currently have, because investors have access to many trading systems, whether it is MTS, MarketAxess or even the single systems. I think investors will really see where banks are quoting a price.
Obviously the size is much smaller than it was in the past, but this is more due to the market and the underlying hedge. From the investors' perspective they will always find their own transparency at much wider levels than in the past.
I also think that you will currently find other data points, for instance in the recent transactions where the primary market is now repricing the secondary market. The transparency you find in the secondary market is therefore a certain size – maybe €20m – and then suddenly you can bring a new transaction to the market at more or less the offer side, or achieve even tighter than where you see the transparency in the secondary market. This means that you have a totally different data point and the whole market is adjusting itself around this new data point.
It is a very interesting situation that we are currently experiencing. If you go with a new transaction, such as a seven-year deal which is a maturity where investors can extend their duration, then different mechanics appear. It's not a data point which easily presents itself.
In terms of the transparency which we had in the past, if we are talking about our 500 outstanding jumbo covered bonds which were market made by the community, you had a transparency. But in the current market environment with the current balance sheet constraints, to keep the same level of transparency as in the past for all those bonds outstanding is very difficult.
IFR: Are there any signals that these balance sheet constraints are beginning to ease or will this be a feature of the market for some time yet?
Elling: Overall banks are still in deleveraging mode. I don’t think this has finished yet. Although we are seeing signs of relief where certain assets can be re evaluated. Provisions which you built up in the past can more or less be got rid of, so that is a very positive signal.
But, in terms of the balance sheet it's still more restricted than where we were before. Obviously the risk appetite in the current market environment is increasing again. With a market like this, where you see a positive spread performance for the product, you can clearly increase your balance sheet. But that is also on the back of being able to increase your client turnover, which at the same time will grow with the amount of balance sheet you increase.
IFR: Is the liquidity focused on the most recent issuance or are the older transactions still being traded?
Elling: Obviously with the latest transactions you have a higher degree of liquidity in the market because you have more turnover. Take for example the recent transactions: there was a positive performance so you try to fill those orders in the secondary market, and then to get bonds back from investors who bought them in the primary market. Of course there's more turnover in those transactions, but nevertheless, given the ongoing demand again not only from central banks, but driven by central banks there is clearly a much higher degree of turnover overall, including those outstanding bonds issued in the past.
Schenk: What we saw during the last week is that the primary market is really important in getting some transparency back into the secondary markets. Because we were absent from the benchmark market for more than a year the secondary market did not provide enough direction on the price. Our new issue really helped in this matter. It increased liquidity in the transactions we had outstanding. Therefore I think the primary market is important to bring some life into the secondary markets again.
IFR: So price transparency is being obtained from the primary market at the moment?
Schenk: It is not only being obtained from the primary markets, but the primary market is definitely helping give some direction to spreads where, without any new issuance, secondary markets perhaps would not go.
Diemer: The tightening of spreads is also helpful for increased liquidity, because there are no sellers to realise real losses especially if they believe in the quality of the product.
Tolckmitt: From an association point of view, we are definitely looking for ways of increasing transparency in the market on an institutionalised basis. We are not just relying on the activities of the primary market.
Going forward you have to think about how to actually create price transparency in the market if the market normalizes. That is the most important thing.
IFR: So how do we go about creating price transparency?
Tolckmitt: We are closely looking at different approaches to electronic trading platforms, including platforms where you do not necessarily trade but maybe have an obligation to quote prices for different issuers.
Viteau: One of the pillars of the covered market in general was to have this market making commitment which has clearly changed a lot. This created a pre trade transparency. Before trading there were prices available at any single time for investors: they could see on the pages the prices displayed by the market makers. They were real tradable prices. Now we've got to a point where there are no tradable prices available to the wider public. But, as Torsten was saying, the investor has got his own transparency. He can ask for the price which then becomes tradable for him.
Maybe we should look at the issue from a different perspective and just create transparency – not necessarily pre trade but post trade also. Every completed trade would be somewhere warehoused and displayed, which may help to obtain some pre trade transparency again. It's a way of protecting the balance sheet of the market maker too, because if you want to have pre trade transparency you need to put the balance sheet on the line. That is what is costing money. At the moment you cannot make a market in 500 bonds. To do so on a continuous basis is potentially very costly. What you can do, on the other hand, is probably display prices after they have traded, because that is real execution. Then you can make it available to a wider range of investors.
Elling: Do we currently have investors complaining about the transparency and the liquidity in the market? It always comes into play if the market is widening, and in the current tightening environment I haven't come across any investor who was really concerned about transparency.
Tolckmitt: Maybe it's the role of an association to be a little more forward looking. What happens if the market normalises? We should not wait until then to think about what can we do to serve investors' needs. We should look to have a solution once the market normalises. It is perhaps true that investors currently are not as concerned in this environment, but things can change quickly. That is what drives us at the association.
With respect to transparency, legislators at a European level are working on extending the current post trade transparency from equity markets to bond markets. That might take one or two years. We would have to see how what we create fits into this new regime, but I'm pretty sure that there is a general understanding that this kind of transparency should come. We should keep that in mind when creating such a system, when we come to set standards in a very important market in Europe. We cannot circumvent it.
It's not the solution, but it is a point to keep in mind when assessing the need for post trade transparency simply because the legislator may say that we need it.
Elling: I'm a big fan of transparency, don't get me wrong. But I'm always hearing "once the market is going back to normal". The question is, what is normal? And when will we achieve the normal status? Then, if we have achieved it, what happens if the ECB buys back their €60bn? The market is continuously moving and readjusting itself. It is a market force which is driven by supply and demand in general. It is difficult to say, "okay, now the market is back to normal let's go back to doing things the way we did it in the past".
Nevertheless transparency has to be increased and it will be increased.
Tolckmitt: It is not about doing it as we did it in the past; it is simply a question of creating clarity.
Sommer: I read today in the newspaper Eurex is preparing a future on Italian BTPs. Would it be appropriate to revitalise the Pfandbrief future to help liquidity?
Elling: It is a very interesting question. The future of the BTP will have a lot of benefits, specifically for the Italian government. It is something that is worth looking at, obviously.
IFR: Has there ever been a derivative market for covered bonds?
Packmohr: We had a future for a very short time.
Diemer: About ten years ago.
Elling: Then we had a limited number of covered bond issuers compared what we have now. It is a very complex product and would be a very complex derivative.
IFR: Is there a need to reintroduce a derivative market in covered bonds?
Packmohr: I think derivatives are not really the flavour of the month at the moment. Structured products in general aren't, are they?
Elling: To return to the question, do we really need the future on BTPs again?
Diemer: Let's see whether that's a success and then we will come back to it!
Rosenberger: What you do need to an extent is a liquid repo market for Pfandbriefe. But a derivative? I wouldn't say so.
Viteau: Is it not a matter of having a proper hedging tool? The future market is created for hedging, arbitrage, or speculative reasons. Can you hedge properly in the Pfandbrief market?
Elling: The current hedges are obviously credit, futures, and swaps. Swaps are still the most common hedge for the covered bonds.
But then we are coming back to the point that if you have a single covered bond future, you would have to hedge different credit risks, different legislations. Then that becomes an imperfect hedge as well. So I can't see the benefits. There are times where you can hedge your positions in a better or worse way and the current hedge methods, which you find for covered bonds in general and for Pfandbriefe in particular, are okay.
Click here for Part four of the Roundtable.