When the credit crisis started the collapse in liquidity in the covered bond market was blamed on the old market making rules. When regulators responded to the crisis, the continued poor liquidity was blamed on the new prudential regulations for market makers. When the ECB responded to the slow down the illiquidity was blamed on QE. Who next I wonder, Brexit? Trump?
The argument about why secondary market liquidity is poor is increasingly moot. The ECB wont stop buying soon, we wont see a huge uptick in jumbo issuance, liquidity sapping regulations will, at best be slightly ameliorated by friendly technical standards as has happened with the Mifid transparency rules but not fundamentally changed.
The plethora of new trading platforms may or may not be a solution. Clearly there are too many currently which is mildly counterproductive for liquidity and absolutely terrible for IT budgets. Hopefully a Darwinian survival of the fittest process will concentrate liquidity in the better systems. But even so, the protocols that most of these systems use, whether it be a request for quote, a continual streaming of live prices or auctions are still essentially voice market trading protocols. They may do things better but they rarely do anything new.
So rather than bemoaning the lack of liquidity and trying to untie the Gordian knot it might be better to spend our time working out how to adapt to the new reality?
Market makers have one big way to adapt to the lack of profitability in this market they can stop being market makers.
In the SSA world we have already seen investment banks surrender their primary dealer status. When they do it is often associated with a withdrawl from DCM in those markets too. It isnt a strictly analogous situation because so much of the SSA business is auctioned, rather than syndicated. But it is pretty clear that when a bank thinks about pulling out of covered bond market making, DCM is going to voice the loudest complaints.
The SSA market has the advantage of a formal commitment, either you are a primary dealer or you arent. In covered bonds it isnt as clear though, a market maker could slowly migrate into a desk that is mainly there to execute client orders or take prop positions. If this is done gradually enough by many banks at the same time would clients even notice? Or would they perhaps ascribe it to the general poor liquidity in the secondary market that investment bankers keep complaining about? Has this already happened?
Could a formal market maker status like primary dealerships in the SSA market - add clarity? Banks could still be specialised market makers in their own niches, bonds that they have underwritten, or their geographical areas for example. But banks would not have to pretend to make a market in bonds of which they know little.
Its an idea, in a market where currently there are mainly excuses. Looking forward to discussing it in the secondary markets panel in Dusseldorf next week.
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