Primary Dealers' Future Questioned in Europe as Rules Sting

  • DMO's Stheeman says willingness to make markets has diminished
  • Primary dealing may extend beyond today's group: Leclercq

Credit Suisse Group AG’s withdrawal from making a market in government bonds in Europe has left everyone from traders to debt-agency chiefs concerned there may be a domino effect of departures that ultimately dries up liquidity for investors.

The future of the primary-dealer model in Europe -- in which governments sell debt largely to approved banks, who often hold the securities for periods of time and smooth liquidity into secondary markets -- appears at risk from regulations that are making fixed-income trading less profitable.

Robert Stheeman

Photographer: Simon Dawson/Bloomberg

The heads of the U.K. and Belgian public-debt agencies said at a bond conference in Brussels last week that just one bank stepping away from the market wasn’t of huge concern. Even so, if this started a trend, or several quit at once, that would be troubling, they said at the Association for Financial Markets in Europe event.

“At the moment, everybody seems to be talking about regulation and liquidity in a way that they weren’t a few years ago,” Robert Stheeman, chief executive officer of the U.K. Debt Management Office, said in an interview at the conference. “Liquidity is also the willingness of the market-making community to take positions. That to me seems to be somewhat diminished, and there is possibly a link directly to regulation.”

Cost Decision

The Swiss bank ended its role as a primary dealer in Europe last month as part of an overhaul of the lender’s trading and advisory services intended to cut costs. Around the world, the biggest banks are shrinking their bond-trading activities to comply with regulations such as higher capital requirements imposed following the financial crisis.

The rules mean they no longer can afford to “warehouse risk” on their balance sheets or build inventory in the same way as before, which has helped guarantee governments there would be buyers for public debt.

Anne Leclercq, director for treasury and capital markets at the Belgian Debt Agency, said that having 10 to 15 primary dealers was sufficient for the nation. However, a key element of the future is how debt issuers incentivize the system, she said during a panel discussion at the AFME event.

Newcomers to Dealing

“You have to make sure there is a system that helps everybody, and everybody finds in that operating model certain profitability,” Leclercq said. “It might be that the primary dealers of today are not exactly the same as the ones of tomorrow.” Future market-makers may also include more regional and local banks, not just the world’s largest lenders, she said.

Primary dealership no longer being the exclusive purview of banks is a view shared by Citigroup Inc.’s head of European government bond trading. If liquidity needs to increase then, like in the U.S., clients may start bidding directly at auctions and other financial companies may step in to make markets, Zoeb Sachee said in an interview.

Credit Suisse’s departure from being a gilt primary dealer was the first instance a bank walked away from the U.K. sovereign-debt market since December 2011.

Bid-Offer Spread

Stheeman said the debt agency doesn’t seek new market makers, but instead it they who must decide to stay based on commercial criteria. If exits lead to the widening of bid-offer spreads and better margins it could actually make the job more profitable for the remaining primary dealers, he added. 

“The number of primary dealers is likely to be closely correlated with actual market activity, with liquidity, and with turnover, because they are in the market to see if they can make money,” Stheeman said. “I am genuinely not concerned about demand for” bonds the U.K. issues. “What concerns me is how we reach the demand,” he said.

Not all see a decline in the number of market makers as a bad thing. There is still too much overcapacity, according to Arjan de Ruiter, head of portfolio trading and finance at ING Groep NV.

“The costs of being a primary dealer have increased for all banks, so some more consolidation is likely, but it may not lead to problems -- at least not in the short term,” de Ruiter said.

End of QE

His concerns lay in the future, when the European Central Bank withdraws its quantitative-easing program and primary dealers are suddenly exposed to more volatility, he said.

The subject was so prolific during the AFME conference that in the final panel, the moderator eventually stepped in to stop discussion and questions on primary dealership to move onto other topics.

Not to much success, when asked what the conference will be discussing in 10 years’ time, ING’s de Ruiter said it was likely still to be the primary-dealer model.

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