The biggest transformation in the history of Europe’s $11.4 trillion corporate bond market has kicked off with dealers and investors asked to adopt changes even stricter than those that prompted upheaval on Wall Street more than a decade ago.
In its efforts to prevent a repeat of the financial crisis, the European Union is seeking to make the credit market more transparent by publicly disclosing bond-trading prices. Dealers are concerned they will suffer the fate of their U.S. counterparts after the introduction of the Trace bond-price reporting system in 2002, when a study found $1 billion in commissions were wiped out in the first year alone.
“There’s a very different market that’s going to come out of this process,” Lee Sanders, a London-based senior trader at Axa Investment Managers Ltd., which oversees $765 billion, said in a telephone interview on May 28. “The arguments about Trace were the same as those taking place now.”
Almost 1,000 pages of proposed rules dropped on the desks of dealers, traders and investors this month after two years of haggling between policy makers. The effort is designed to give all participants equal access to real-time data, stripping dealers of their traditional advantage. It’s also meant to help regulators better monitor the links between different parts of the financial system to improve oversight.
Like bond markets almost everywhere, Europe’s has ballooned as borrowers take advantage of near-zero interest rate policies implemented by central banks in the wake of the worst financial crisis since the Great Depression.
European companies have the equivalent of about 8.4 trillion euros ($11.4 trillion) of bonds outstanding in various currencies, up from 6.3 trillion euros at the beginning of 2008, according to data compiled by the European Central Bank. The average cost of borrowing has slumped to records in the region, with yields on investment-grade debt at 1.5 percent and yields on high-yield notes at 3.5 percent, Bank of America Merrill Lynch index data show.
Bankers say the plan would drain liquidity out of a credit market where it’s already become more expensive to do business as new rules require trades to be backed with greater amounts of capital. Firms from London-based Barclays Plc to UBS AG in Zurich blamed slumps in their European fixed-income businesses for declines in first-quarter profit.
“The focus of legislators was transparency,” said Arlene McCarthy, former vice-chairwoman of the European Parliament’s Economic & Monetary Affairs Committee, which steered the legislation through the lawmaking process, said in a telephone interview this week. “Big institutions can trade in the dark, and that isn’t fair to other investors. We wanted to level the playing field for the smaller player.”
The proposals echo the introduction of the Trade Reporting and Compliance Engine in the U.S., which acts as a window into the nation’s corporate bond market. Under Trace, trades must be reported within 15 minutes of execution and investors rely on it to decide how much to pay for a security and to determine the value of the bonds they own.
Regulators in Europe are planning to go a step further with their reporting requirements than Trace.
Under the plan, traders will have to post prices and amounts of trades before deals are completed as well as afterward. That transparency may allow rivals to profit by changing prices when they see large trades coming to the market, said Carl Sells, a London-based senior trader at AllianceBernstein LP, which manages about $445 billion.
There’s a risk Europe’s moving too far, too fast, according to Christine Kenny, who was a senior trader at fund manager Loomis Sayles & Co. in Boston when Trace started.
“In Europe it’s going to be brought in rather quickly across asset classes whereas in the U.S. it was phased in over many years -- a decade really,” Kenny, who is now co-head of the firm’s London office, said in a telephone interview on May 15. “They might be giving themselves an awfully large task if they do it too quickly.”
After the European Parliament approved an update of its Markets in Financial Instruments Directive, or MiFID, in April, the European Securities & Markets Authority was given the task of defining the new terms and rules. ESMA will hold public hearings on the proposals in July and accept feedback from the market until Aug. 1. It will recommend changes to the European Commission by December.
“The objective is to bring light to the dark parts of the capital markets,” Steven Maijoor, chairman of the Paris-based ESMA, said in an interview at Bloomberg’s London office on April 16. “We’re expanding that light to bonds, derivatives and other instruments.”
Dealers say they have a central role in providing liquidity for the biggest trades and rules requiring greater transparency put that business at risk. Banks and the largest fund managers can hold bonds until a buyer can be found and they risk being disadvantaged by having to publicize those positions, according to Tim Gately, the London-based head of European credit trading at Citigroup Inc.
“The devil is in the details,” he said in an interview May 28. “The broad-based rules have been laid out but the way they are implemented will really clarify the ultimate direction the market goes in.”
Rather than boost staff to handle the 30 percent increase in outstanding bonds since 2008, European banks are reducing trading to counter the rising cost of meeting regulatory demands.
Barclays said May 8 it’s laying off 7,000 staff, or 25 percent of employees at the investment bank. While UBS’s Chief Executive Officer Sergio Ermotti said in a Jan. 13 Bloomberg Television interview UBS is still committed to maintaining its investment bank, it’s in the process of cutting 10,000 jobs and exiting most of its debt-trading business.
Revenue from fixed-income trading fell by an average 16 percent in the first three months of the year, according to data compiled by Bloomberg Industries from nine firms worldwide. Income at Barclays tumbled 41 percent in the quarter, while at Frankfurt-based Deutsche Bank AG it slipped by 10 percent, the data show.
Wall Street bond traders lost commissions after Trace was implemented when the difference between bids to buy and offers to sell corporate bonds narrowed in the first year of the price reporting rules, according to a study published in the Journal of Financial Economics in 2006. Smaller dealers gained market share at the expense of larger ones as all traders were able to share the same prices, according to the study, which compared trading data from before and after the introduction of Trace.
In the U.S., the additional transparency helped to reduce trading costs for smaller asset managers and traders.
“Greater transparency will give us a deeper, more liquid market,” Mark Holman, chief executive officer of Twentyfour Asset Management, which has $3.9 billion of fixed-income assets, said in a telephone interview on May 27. “The buy side has plenty of cash. The trouble is, we have to go through a pipe that is the dealers and that pipe has become much narrower recently.”
The average bid-ask spread, a measure of the cost of trading, is currently about 40 percent lower in the U.S. than in Europe, according to data from MarketAxess Holdings Inc., which runs a trading platform.
Expressed as a percentage of face value, the spread is an average of about 0.25 percent of par in the U.S., compared with 0.4 percent in Europe, the data show.
The bid-ask spread on Verizon Communications Inc.’s $1.25 billion of 4.15 percent notes due March 2024 is 0.35 percent of face value, according to Bloomberg composite prices. The spread on Vodafone Group Plc’s 1.25 billion euros of 4.65 percent bonds maturing in January 2022 is 0.54 percent of par.
“There’s nobody in the U.S. who would tell you in 2002 they were 100 percent excited for Trace because we didn’t know what it was and we didn’t know what it meant,” said Kenny at Loomis. “Until you’re in the midst of it and see how it affects your day to day job you don’t really know.”