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Here we go again.

21 November 2019

The fourth instalment of the ECB’s covered bond purchase programme has the potential to inflict lasting damage on the covered bond market, its modalities and implications need even closer scrutiny. But then we said that last time, too.

Its shocking to think that no covered bond trader younger than their mid 30s can remember a time when the ECB didn’t dominate covered bond trading. These purchase programmes really have been around for over a decade and, I think is fair to say, we’ve all gotten a little tired of them.

The announcement of the first covered bond purchase programme – a now modest, at the time shockingly large €60bn – was one of those ‘death of Kennedy’ moments. I was travelling at the time and heard about if via a text from a friend in the securitisation market. He suggested that the ECB’s decision to favour covered bonds over ABS was predicated on unrealistic analysis of the empirical evidence on credit performance. The exact words he used are less repeatable; he is Scottish.

The overall reaction of the market was euphoric. Not so much the impact of the news on spreads, they were tightening anyway, but on market capacity. Now we think of ECB purchases as crowding out private sector investors and adding nothing to the total capacity of the market; then we thought that not only would they fund €60bn of new term funding for recovering banks but, if anything, their vote of confidence in the market would encourage new investors.

How times have changed.

It is with heavy hearts that we start the fourth – please God the final – purchase programme. We all know the story, squeezing out investors, distorting relative value, killing liquidity, privatising the business of DCM….

What can be done? On a macro scale, nothing. This purchase programme is the covered bond market helping the ECB, the first was the exact opposite. If Ms Lagarde even knows what the covered bond market is she probably has vey little concern about collateral damage to it as a result of QE.

On a micro-scale? Perhaps more.

A lot of traders and syndicate officers complain about the way in which the ECB buys bonds in primary. Like all investors they want best execution, and they retain favourable treatment from banks, so they approach new issues now as they always have: come in late and expect full allocation. That may have been appropriate when they were putting €50mn orders into €1bn books. It isn’t now. Any other investor who acted like that would be given short shrift in the allocation market. Shouldn’t the ECB think about new ways to submit orders? Acting like a regular investor with their own view of relative value? Or committing to take a fixed proportion of any fully subscribed deal that meets their criteria at a market clearing price? Relinquishing their preferred allocation status?

Then there is the secondary market. Instead of circling trading books looking to pick up any loose bonds, couldn’t they have a less disruptive approach? For open market operations they simply publish a list of bonds for repo operation and provide liquidity against them. Could secondary desks sell eligible bonds to them via some form of daily auction?

Whilst we are on the subject, which bonds are eligible? The ECB is known for its concerns about conditional pass through bonds and flexibility on most other criteria. But the covered bond market is developing. Could the ECB encourage sensible development by saying, for example, that they will give favourable treatment in their purchase programme to conditional pass through bonds that meet certain minimum structural standards? Or that they will happily add to their buy list structured covered bonds secured on non-mortgage green loans?

They could also do a lot to de-sensitise the covered bond market to regulatory ‘cliff risk’. One of the hidden risks in the covered bond market is that a covered bond that suddenly fails to meet, for example, the criteria to be a bank liquidity asset could fall a long way, very rapidly. If the ECB’s purchase criteria were simply based on different triggers to those influencing regulatory treatment they could buffer the market from such shocks.

There are potentially many things that could be done to limit the damage of the new programme. I’m no trader, the above are only suggestions. But surely as the potential damage to our market grows, so to does the onus on the ECB to engage in a formal public consultation with the market on damage limitation.

By Richard Kemmish