It is one of the great ironies of the European bond market that one of the largest market distortions occurs within the sovereign sector and are caused by the direct actions of Europe’s sovereign debt managers. The regulatory environment in Europe is tighter than ever, with the EU taking an aggressive and sometimes misguided stance in its aim of eliminating distortions in the capital markets, notably with its Market Abuse Directive and MiFID. And yet, despite all the EU’s talk of market efficiency, it ignores the market abuse happening right under its nose.
By using the promise of winning syndicated bonds as a carrot/stick, sovereign debt managers across the continent are able to demand that their primary dealers outperform at auctions and provide liquidity on both on- and off-the-run government bonds. An increasing proportion of sovereign debt is sold via syndication – up from €70 billion in 2000 to €158 billion so far this year. European government bond mandates are essential to investment banks that want to maintain a serious fixed income franchise.
Off the record – they can’t be quoted, they’ll lose those all-important mandates – bankers say that many of Europe’s debt management offices are abusing their power over their primary dealers to keep costs of issuance down.
You can’t blame the debt managers. They are under enormous pressure themselves as government budget deficits balloon. So at auction they encourage dealers to bid paper aggressively tighter, on average by 10–15 cents beneath the market level.
A pincer move is completed by secondary market commitments to provide liquidity in on- and off-the-run securities. Many banks employ at least one trader just to ensure accurate pricing on illiquid bonds that never trade. The debt managers might say they are simply benefiting from competitive pressure in investment banking. But, if that is true, why do they measure the banks’ performance on the euroMTS electronic trading platform?
Sovereigns, therefore, manipulate the market in a similar way to how European corporates link the lending and bond businesses. It is worth noting that this practice was stopped in the US, but the anti-trust authorities have teeth on that side of the pond.
The mis-pricing of auctions tends not to be a function of the UK gilt market, as historically the UK DMO offers no ancillary business. But the same cannot be said for continental Europe.
Part of the reason why Citigroup so severely angered the European debt managers by taking advantage of this false liquidity with its now notorious Dr Evil trade in August 2004 is that it put the cosy little arrangement at risk. Estimates for the collective loss of revenue to banks from this activity range from $250 million to $400 million each year.
Few will weep any tears over Citi’s loss of face. But it is the wider market that is the big loser in this, not just the various investment banks that are forced to pay to play. It’s got so bad that all the top banks meet up to decide how much the auction premium is going to be. Because of the auction premium, investors do not participate in auctions.
In whose interest is that?