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Last chance to see

24 July 2014
Richard Kemmish

The BBC has a great tradition of sending sweaty camera crews to remote jungle locations to film utterly irrelevant endangered species “...<in hushed, reverential tones>.... here we see the last surviving three-eared Madagascan ladybird”.

Perhaps they should send a camera crew to Frankfurt to record covered bond traders in their natural habitat before its too late.  A few years ago the population of covered bond traders in the wild was in excess of 50, one German bank alone boasted of having 12. That the market could support so many was due to an abundance of their only known food, balance sheet capacity. They thrived in the natural, if artificially protected environment of market making and, like the dodo when it first saw humans, had no concept of fear when they saw volatility.

So why are they on the endangered list? The old market making conventions created some very unrealistic expectations, (‘No matter that a bond was only 750mn when it was launched three years ago, I still want you to quote on a 50mn ticket’). Providing that level of service required two things.

Firstly, you needed a large, cheap balance sheet to park the bonds whilst the sales force slowly chipped away at the position.  Large balance sheets are not supposed to be about market makers taking large positions as proprietary trades (although sure, that happened too) but about buffering flows from end customers. German banks, the cheapest balance sheets in town before the crisis, were hardest hit. The other heavy user of trading books, the government and agency businesses at least had the advantages of larger issue sizes (therefore easier to exit that big ticket) and a certain kudos – government primary dealer status is a thing banks are prepared to subsidise. Market maker for Eurohypo, not so much.

Secondly, you need opacity. No use being able to park that block if the rest of the market knows it is there, what level you bought it at and how much pressure you are getting from management to offload it. Which is why MIFID 2 is such a problem.

Mifid is many things to many people, but for covered bond traders it creates three problems, two surmountable, one probably terminal. The easy to solve problems are about trading venues (stock exchanges, multilateral platforms, internal matching books) and about pre-trade price transparency. To cut a (very) long story short, these can probably be resolved. But post-trade transparency is the real problem.

As traders in the US bond markets discovered when TRACE was introduced there, there is nothing quite so damaging to your ability to make markets as the whole market seeing the levels that you are doing it at. We can, and will, argue the details – delayed reporting for market making tickets for example – with the regulators but the days when large blocks of bonds could move around silently are over.
This topic will be discussed in Vienna in the traders roundtable at 11:30. Come and hear the trader’s thoughts. It might be your last chance.

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