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Macaskill on markets: Europe reveals much through what it is trying to hide

The reluctant decision by European governments to publish stress tests for their domestic banks might shed an unwelcome light on the illiquidity of many local sovereign debt markets.

Jon Macaskill is one of the leading capital markets and derivatives journalists, with over 20 years’ experience covering financial markets from London and New York. Most recently he worked at one of the biggest global investment banks

Jon Macaskill is one of the leading capital markets and derivatives journalists, with over 20 years’ experience covering financial markets from London and New York. Most recently he worked at one of the biggest global investment banks

The move towards public stress testing for eurozone banks was handled with the combination of opacity and confusion that has come to characterize the European sovereign debt crisis and is exacerbating its effects. Spain’s announcement that it intended to publish the results of stress tests for its banks forced France, Germany and Italy to follow suit. Spain’s unilateral move followed a couple of weeks of sharp widening in credit spreads for Spanish borrowers and restricted access to markets, as worried investors shifted their focus from cutting exposure to Greece. A Spanish conviction that its banks are in no worse shape than those in other important European economies led to the decision to go it alone with stress test publication if necessary and underscored the inability of eurozone governments to coordinate crucial policy decisions.

Once France, Germany and Italy had been forced to agree to publication of stress test results for 25 big European banks at a European Union summit in late June there were immediate attempts to limit the scope of the process. A key step was a decision to limit disclosure of the exposure of banks to local sovereign debt.

Many politicians and regulators clearly hoped to avoid undue attention on sovereign debt exposure but once again their actions are likely to have the opposite effect to their intentions. The growing illiquidity in peripheral European sovereign bond markets would be highlighted in any stress-testing process that used widely available risk-management techniques.

As the sovereign debt crisis developed in May, bid-offer spreads in Greek debt moved as wide as 16 points, according to Tradeweb data. That amounted to an effective breakdown in the market for the country’s sovereign debt, with a sharp increase in the number of failed attempts to trade online corroborating the impact of the spread widening. Bids typically meet offers well over 80% of the time in the online market, but the hit rate for Greek government bond trades fell as low as 45% as bid-offer spreads widened. A similar trend was later seen in Spanish government debt, with the hit rate falling below 60%.

The demonstrable illiquidity of the peripheral European government bond markets should be factored into stress tests for the sovereign paper held by banks and a haircut should be applied to their value. But this step seems unlikely in the test results that are due to be announced in July.

While eurozone governments are trying to sweep sovereign debt exposure under the carpet, they have all but closed down the market for hedging government bonds with credit default swap trades. Peripheral eurozone bonds now cannot be sold except at fire-sale levels and can only be hedged with great difficulty. This increases the likelihood that banks will try to value sovereign bonds at artificially high prices or attempt clumsy macro hedges of their exposure, which could in turn create further problems if there is market disruption along 2008 lines later this year or in 2011.

Unexpected correlation of supposedly offsetting positions was one of the main factors in the market breakdown of late 2008 and it could easily return.

The vocal and at times hysterical opposition to credit derivatives by some European politicians and regulators has made providers of liquidity in an array of other markets re-examine their exposure to regulatory and reputational risk. The market for sovereign credit default swaps on developed nations was a niche sector until recent years. Hedges of emerging market sovereign risk were routinely seen for good size from the late 1990s onwards, as a default swap was often crucial to the ability of banks to structure deals that offered credit to borrowers in low-rated countries.

Default swaps on G20 nations were largely the province of a few investors with an appetite for tail-risk hedging, or simply a contrarian view on the nature of sovereign risk. When some hedge funds expressed a desire to buy default swaps on US government exposure the main bank dealers were happy to pocket what they thought were a couple of free basis points in premiums, often with a chuckle at the expense of the doom-mongers who worried about the credit quality of the US government. It is certainly true that it is difficult to conceive of a situation where the US could default on its debt while big banks were simultaneously still in a position to pay out on sovereign credit default swap trades.

But the deals worked as trading positions. They were often executed at levels of two or three basis points, while US default swaps in the standard five-year maturity were quoted at a 38bp mid-point in late June this year, according to Markit data. Federal Republic of Germany five-year default swaps were also at 38bp in late June, sharing the honours for the tightest major sovereign default swap spread (France was at 77bp and the UK at 79bp).

Repeated complaints by German officials about supposed abuses in the sovereign default swap market and a ban on naked short selling via CDS for institutions based in Germany had severely reduced liquidity in the market, however. The ban on naked short CDS positions was another example of a unilateral move by a European government that reduced liquidity while serving no clear purpose.

The German move was particularly bumbling, as it only covers trades done in Germany, while most default swaps close in London or New York. This means that any German institution with a UK subsidiary can continue to buy naked default swaps on the list of credits covered by the short-sale ban, if so inclined. But the move had a chilling effect on the entire default swap market and caused both hedge funds and major bank dealers to re-examine their approach to managing risk.

This trend could eventually affect liquidity in markets that are now considered so smoothly functioning that they barely warrant any regulatory attention or investor concern. Some hedge funds are starting to consider the possibility that they will face public condemnation or sanctions for currency trades that involve selling exposure to the euro, for example.

George Soros came in for some opprobrium when he netted about $1 billion betting on a sterling devaluation in 1992 but he was not hounded by politicians or regulators for correctly betting on a fall in the currency. If hedge funds feel they should err on the side of caution on future currency trades, then eurozone politicians might manage to hamper trading in even the most liquid wholesale market of all – the euro-US dollar foreign exchange cross.

Bankers hunt for friends in high places