The number of banks reviewing their primary dealership commitments is on the rise as they weigh up the costs versus the returns, leading to questions over liquidity and pricing.
A rise in the number of banks giving up primary dealer roles in European government bond markets threatens to further reduce liquidity and eventually make it more expensive for some countries to borrow money.
Increased regulation and lower margins have seen six banks exit various countries in the recent months. Others look set to follow, further eroding the infrastructure through which governments raise debt.
While these problems are for now masked by the European Central Bank buying €60bn of debt every month to try to stimulate the eurozone economy, countries may feel the effects more sharply when the ECB scheme is scheduled to end in March 2017.
Since 2012, most eurozone governments have lost one or two banks as primary dealers, while Belgium – one of the bloc’s most indebted states – is down five.
Primary dealers are integral to government bond markets, buying new issues at auctions to service demand from investors and to maintain secondary trading activity. Without their support, countries would find it harder to sell debt, forcing them to offer investors higher interest rates.
Over the last quarter alone, Credit Suisse has pulled out of most European countries, ING has quit Ireland, Commerzbank has left Italy, and Belgium did not reappoint Deutsche Bank as a primary dealer and dropped Nordea as a recognised dealer.
Most recently, Societe Generale decided to stop acting as a primary dealer for UK government bonds.
“The regulatory framework is unfortunately more and more restrictive. So we are trying to refocus on our core activities,” said a Societe Generale spokeswoman in Paris.
The Credit Suisse decision to pull out of all European primary dealerships was the one that really shocked the market.
“What CS did is a stupid thing because they will never recover from that,” said one DCM official who covers public sector debt. “UBS, for example, decided to exit SSA more or less, but they still maintained one or two primary dealerships. Deutsche Bank is keeping all its primary dealerships but committing less capital.
“These banks will have the option of coming back in two, three years’ time. What CS have done is one of the most stupid things to do.”
A second was more understanding, however.
“The costs have gone up in fixed income markets, and several banks are having to clamp down on overly leveraged balance sheets,” said a head of SSA DCM at a bulge-bracket bank. “People have to choose where to employ that capital, and they won’t always choose government bonds.”
CS will continue to act as a primary dealer in US Treasuries, but the exit from European government bond markets is one of the most concrete examples of the investment banking cuts that its chief executive had said would be needed.
New Credit Suisse chief executive Tidjane Thiam said in October last year that the bank would need to raise SFr6bn (US$6.16bn) from investors, slim down its investment bank and cut jobs.
Deutsche Bank has also been under pressure in recent times. The German bank’s shares recently fell to their lowest level for more than 25 years, taking their slump this year to more than 40% at the time. Its bonds and Additional Tier 1 securities also sold off aggressively.
The stock tumbled amid concern the German lender may need to raise capital again to strengthen its balance sheet as the bank gets battered by litigation costs and weak trading results.
Fourth-quarter results for its investment bank were also far weaker than at its US rivals.
It has not been alone in the banking sell-off, as analysts said concerns about losses from energy loans, the negative impact of low interest rates and a gloomy outlook for the European economy were all dragging on sentiment.
Against this gloomy backdrop, only Danske Bank has in recent times added to its primary dealer roles in the bloc’s main markets. But even Danske is worried.
“I’ve never seen it so bad,” said Soeren Moerch, head of fixed income trading at Danske Markets. “When further banks reduce their willingness to be a primary dealer, then liquidity will go even lower … we could have more failed auctions and we could see a big washout in the market.”
Rising cost
Acting as a dealer has become increasingly expensive for banks under new regulations because of the amount of capital it requires, while trading profits that once made up for the initial spend have diminished in an era of ultra-low rates.
“Shareholders would be shocked if they knew the scale of the costs that some businesses are taking,” said one banker who has worked at several major investment houses with primary dealer functions.
The decline in dealers comes as many of the world’s largest financial firms, such as Morgan Stanley and Deutsche Bank, launch strategic reviews that are likely to impact their fixed income operations.
The risk that the eurozone could slide back into recession, having barely recovered from its long-running debt crisis, could exacerbate the withdrawal by prompting banks to retreat into their home markets.
“It is a negative trend; the opposite from what we saw in the first 10 years of the euro,” said Sergio Capaldi, a fixed income strategist at Intesa Sanpaolo. “For smaller countries … the fact that there are less players is something that could have a negative affect on market liquidity and borrowing costs.”
Tough obligations
Bankers said it was getting harder to justify the costs of being a primary dealer, even though they establish a relationship with governments that can generate other revenues in areas like derivatives and privatisations.
Seeing a once-dominant player like Credit Suisse leave in October has, for some, made it obvious that they themselves will have to slim down if they want to continue.
A second banker, who oversees more than a dozen European dealerships, said he had told his managers he wanted to exit two countries.
Banks may also find themselves turfed out by governments if they are deemed to be doing only the bare minimum to stay in the hunt for other fee-paying business. In December last year, Belgium did not reappoint Deutsche Bank as a primary dealer for 2016, after conducting a performance review of all its market-makers.
“Regulation has put a lot of pressure on primary dealers,” said Victoria Webster, a fixed income specialist at financial markets trade associate AFME.
“Although the government bond markets and auctions have held up well during the crisis, banks are exiting the market whilst DMOs (debt management offices) are reconsidering the optimum number of primary dealers.”
The obligations that countries place on primary dealers vary. Some demand that they buy a defined percentage of new debt issued over the year or offer trading prices to investors for a set number of hours each day, while others are more flexible.
While it pulled out of most European markets last year, Credit Suisse has remained in Greece, where obligations are less onerous than elsewhere in the currency union.
There are signs that some governments are prepared to adapt their processes in the future.
“We know markets are changing, that the process of distribution is different from what it was a few years before,” said Anne Leclerq, director of treasury and capital markets at Belgium’s debt agency.
“The fact that banks have more constraints is something that … will push us to rethink some elements of the distribution.”
Others, though, see no need for change.
“We don’t think it’s necessary to incentivise current or prospective primary dealers. There will always be some level of turnover,” said Frank O’Connor, director of funding at Ireland’s debt agency, which saw its first dealer exit since 2009, when ING left at the end of last year.
Robert Stheeman, chief executive of the UK Debt Management Office, had previously said increased regulation had reduced liquidity in the UK government bond market, increasing the risk of bond auctions failing to attract enough demand.
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