Macaskill on markets: Credit traps for buy-side giants

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By:
Jon Macaskill
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Norway’s sovereign wealth fund has decided to steer clear of corporate bonds, which will help it to avoid the reputational traps that loom for some other large investors.


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Illustration: Kevin February


The corporate credit markets are booming. Issuance volumes are high and default rates are low, with spreads to government debt tight. Secondary market liquidity is decent for recently issued bonds of benchmark size and is improving for credit derivatives linked to corporate debt.

Important decisions surrounding the issuance and trading of corporate debt are still made with very little public disclosure, however. This poses a reputational threat to investors such as BlackRock and Pimco that both act as anchor buyers of new deals and sponsors of secondary market trade venues.

Norway’s sovereign wealth fund – the biggest of its type in the world with roughly $1 trillion of assets – announced at the beginning of September that it is changing its approach to fixed income investment to focus only on holding government bonds with a limited maturity in just three currencies: US dollars, euros and sterling.


Important decisions surrounding the issuance and trading of corporate debt are still made with very little public disclosure, however. 

The fund does not plan a fire sale of its existing corporate bond holdings or a ban on credit trading, but its new approach will allow it to avoid future involvement in primary issuance and conflicts over secondary credit market structure. 

Asset managers avoided the opprobrium suffered by investment banks after the credit crisis of 2008 and also sidestepped the most onerous changes to regulation. 

Closer scrutiny of the mechanics of the credit markets could nevertheless embarrass some leading buy-side players, even when they have acted without ill intent.

Preferential

There have been complaints about preferential treatment for big investors in the primary market for corporate bond launches for years, and sporadic investigations by regulators into allocation practices, although there have not yet been significant charges of abuse or supervisory pressure for fundamental changes.

There are also potential conflicts of interest in secondary credit market trading that could eventually trouble big asset managers.

Recent bickering over whether or not to declare a credit event and trigger the exercise of default swaps on energy trading firm Noble was framed largely as a dispute between rival bank dealers. Goldman Sachs and Nomura were reportedly keen for the relevant determinations committee administered by the International Swaps and Derivatives Association (ISDA) to declare that Noble had restructured its debt so that their holdings of default swap protection could be exercised, while BNP Paribas and JPMorgan were believed to oppose declaration of a credit event because they were sellers of protection. 

As confusion mounted over why a ruling could not be agreed on whether a Noble loan extension constituted debt restructuring for default swap purposes, the role of the asset managers that serve alongside dealers on ISDA’s determination committees drew attention.

Despite extensive work to create governance codes for these committees, key aspects of their workings remain mysterious to outsiders. The way certain asset managers emerge as the five investor representatives on determination committees alongside 10 of the usual dealer suspects is one of those mysteries.

There are publicly available rules on how an asset manager can apply to join a determination committee, including requirements such as demonstrating credit derivatives volumes. There is also a blackballing function, however, as an application can be denied by a two-thirds vote of the existing non-dealer committee members.

That means that a group of six of the eight current non-dealer committee members of Alliance Bernstein, Citadel, Cyrus Capital, Eaton Vance, Elliott, King Street, Pimco and PGIM could block a rival investor from getting a seat at the table to help decide whether and when to declare a credit event for a corporate borrower. 

The current non-dealer committee members are all US based, unlike the designated dealers who also sit on determinations committees and are drawn from a list of international banks. A further quirk in the line-up is that while Citadel, the hedge fund founded by Ken Griffin, is on the broad determinations committee as a non-dealer, Citadel Securities, which Griffin founded as an independent market maker, is expanding its activity as a credit derivatives dealer to compete with banks for market-making revenue.

These oddities and ambiguities seem ripe for lawsuits or regulatory investigations and there are other aspects of secondary credit trading that could also lead to reputational issues for asset managers.

One is the way in which they allocate flows to different electronic trading venues. 

Stranglehold

Tussles between dealers over sponsorship of electronic platforms are common. Bank chief executives collectively regret the way they allowed Michael Bloomberg to generate a personal fortune of roughly $50 billion from a business founded on data sourced from banks, and are keen to prevent trading venues from dominating fixed income electronic deal execution the way that Bloomberg developed a stranglehold on messaging about trades. Banks also fight to obtain the best terms for their own dealers and to defend or extend market share.

Asset managers are inevitably drawn into these turf battles and top firms know that they have enormous ability to wield influence.

The biggest asset manager in the world today is BlackRock, which has over $5 trillion under management, and is in a unique position to influence market structure issues after it helped regulators and banks to establish the value of complex securities in the years after the 2008 credit crisis.

This sway helped BlackRock to thwart a recent attempt by a big dealer to encourage peers and clients to reduce the amount of credit business conducted over the MarketAxess platform, according to market participants.

BlackRock did not want to discuss the details of its muscle flexing, but it did provide a statement outlining its approach to credit venues from Richie Prager, head of the trading, liquidity and investments platform at the firm.

“We began our partnership with MarketAxess in 2013 when we announced the creation of a unified, electronic trading solution in the US credit markets and we remain as committed to that partnership as ever. As evident in MarketAxess’ latest earnings report, there continues to be strong growth in both their ECN and open trading platforms. Our commitment to electronic trading platforms extends beyond MarketAxess, and we work with various ECNs in our effort to reduce liquidity fragmentation and improve pricing across credit markets,” Prager said.

There is a no reason at all why BlackRock should allow a Wall Street dealer – or a cabal of dealers – to dictate how market participants should direct flows. Nor should asset managers be condemned for challenging existing oligarchical practices on the part of dealers. But big asset managers often have similar conflicts of interest to banks. BlackRock is not just a partner with MarketAxess in the “open trading” initiative that Prager referred to, but funds managed by BlackRock are also the second largest institutional shareholder in the firm, for example.

A by-product of the move by Norway’s sovereign wealth fund to simplify its fixed income portfolio will be avoidance of some of the thornier issues in the corporate credit markets. Other big asset managers would be wise to evaluate their own exposure to potential reputational challenges, and hope that Wall Street dealers are the focus of any future investigation of market practices.