Europe’s debt management offices are set to put in place a new mechanism for monitoring their primary dealers’ performance in meeting quotation obligations. The European Primary Dealers Association meeting that takes place on October 24 is likely to see market participants approve proposals discreetly made in May by Belgium, Denmark, Finland and the Netherlands that seek to reconcile the DMOs’ objectives of monitoring their primary dealers’ market-making obligations with supporting competition among electronic trading platforms.
DMOs use the EuroMTS platform to measure the performance of their primary dealers. Before the euro was introduced, the smaller European sovereigns’ debt was marginalized to a large extent because dealers concentrated on trading the larger markets such as Germany, France and Italy. So these peripheral countries embraced MTS – which was the first platform to give them the ability to check on quotation obligations electronically. They made secondary market-making commitments on the trading platform part and parcel of score cards used to evaluate overall primary dealership performances. Scoring well is essential to winning the bond mandates that pay fees and boost new-issue league table positions.
But this arrangement has raised the ire of other platform players that have complained that it effectively amounts to unfair competitive practices. Earlier this year the European Commission revealed that it was looking into government bond trading but not conducting a full-scale investigation. It would appear that the peep did the trick.
Under the EPDA proposals, DMOs and primary dealers will nominate those platforms eligible for meeting market-making obligations. From there on primary dealers will be free to select any platform for meeting their market-making obligations. Primary dealers then have to be a market maker on at least one platform – it seems unlikely that there is any possibility that they will choose more than one – they must also take part as a market taker, at least on all the other eligible platforms, in order to preserve market depth.
Prices will be aggregated via what is described as a virtual market server using an integrated front end. This server will be connected to all eligible platforms, or primary dealers and data-vendors. This virtual market server sounds remarkably similar to LiquidityHub in a number of ways. The latter markets itself as a multi-distributor, multi-dealer liquidity aggregator for fixed-income markets (see Euromoney, August 2007, p62). It will start operating in the coming weeks, first in interest rate swaps and then US government bonds. Pooling of European government bond liquidity will start at some point, most likely in 2008, but no date has been set as yet.
One of the main differences between the two is that it is envisaged that data from the virtual server will be accessible via various data vendors whereas LiquidityHub is currently just linked to Bloomberg and Reuters. Also, the pricing protocol will be request for price on the virtual market server as opposed to request for stream on LiquidityHub.
"The basic priority for the sovereigns is that they want the virtual server to collate data to report quotation obligations. Thus they will be able to monitor quotation obligation compliance," says one European, sovereign, supra and agency debt originator.
The virtual market server might even have a tool that would enable DMOs to allocate bonds to their primary dealers. The potential platform candidates are, EuroMTS and the Greek standalone system HDAT, ICAP/BrokerTec, SENAF, Bloomberg, Eurex Bonds, and BGC/e-Speed.
System breakdown
This summer’s events have seen the whole system of quotation obligation breaking down. Phenomenal volatility has been an everyday occurrence for bond market traders, for government bonds and interest rate swaps. In such circumstances quoting becomes virtually impossible and the quotation obligations rules set out by the DMOs simply do not work. Benchmarking everyone against a fixed bid/offer spread is inappropriate.
"What has happened is that traders have said: ‘I can’t possibly quote this morning, and there is no point in quoting this afternoon because there is no way I’ll be able to meet the five-hour minimum requirement – so I won’t bother.’ There is no mechanism to encourage dealers to try their hardest with regard to market-making," says one banker.
It is understandable that DMOs of smaller countries worry that price transparency on their bonds would suffer if their primary dealers were not obliged to quote. But it might be that this autumn brings about wider changes in how to judge dealers’ best efforts.
Also if primary dealers are allowed to carry out their obligations on any eligible platform, that must surely trigger a debate around how involved DMOs can be in deciding what platforms are eligible, especially given that some own stakes in local MTS entities. And how appropriate is it for a sovereign to be closely aligned to one broker/platform?
Change-of-control clauses are triggered through the formal closing of the Borsa Italiana purchase of MTS in mid-September. Various DMOs will have an interesting decision to make, as will MTS. No formal position has been taken on the contentious matter of allowing third-party access (by hedge funds) to the platform.
The supervisory board of MTS meets in late September when the matter is up for discussion but market insiders believe the decision has been put on hold.
Given the stakes it would be understandable if the MTS management were wary of making strategic mistakes. Embracing third-party access from hedge funds might hand the market over to new competitors at a stroke.