The Association of German Pfandbrief Banks (vdp) is preparing to introduce a revised market-making system at the beginning of 2012 that places at its centre the quotation of covered bond prices to investors and will operate in tandem with a secondary market transparency initiative.

The vdp’s former market-making system was primarily an inter-dealer quotation regime that formed part of “minimum standards” aimed at ensuring the liquidity of jumbo Pfandbriefe, with market-making in turn covered by minimum standards such as the quoting of two way prices with maximum bid-offer spreads. The system broke down in August 2007 after the onset of the financial crisis and never recovered, with the vdp since deciding to work on a successor regime that it intends to roll out early next year.

Sascha Kullig, head of capital markets at the vdp, acknowledged that the former market-making system was somewhat controversial, but said that the vdp is continuing to refer to market-making to describe the amended minimum standards.

However, the vdp is clearly distinguishing the revised regime from the former market-making system, he said, in that while the latter was focussed on inter-dealer price quotation, the new system places investors at the centre.

“It obliges market-makers to quote prices to investors,” said Kullig. “If they want to provide other market-makers with quotes they can of course do so, but there is no obligation under the new minimum standards.”

As under the old arrangements, the revised market-making system requires that each jumbo Pfandbrief have at least five market-makers who pledge to quote prices, although this time there is no obligation to quote two-way prices – with this instead becoming an on request service – and no maximum bid-ask spreads.

Key to the new market-making system is a secondary market transparency initiative under which the vdp will calculate and publish median spread data of jumbo Pfandbriefe on a daily basis based on spread indications provided by participating banks. This, said Kullig, is to make up for the move away from maximum bid-offer spreads under the old system.

“We have chosen to proceed with a more flexible market-making system,” he said, “but to compensate for that we decided we needed to provide a minimum degree of secondary market transparency, especially for those investors who are not necessarily in the market on a daily basis.”

A test phase has been running for several months, with 11 banks participating so far and the vdp in discussions with several others. The goal is to have 15 banks providing daily spread indications for jumbo Pfandbriefe with a residual maturity of at least 24 months, with the data sent to a third party that will automatically compute a median spread for eligible individual bonds.

“The technical implementation is not straightforward, which is why the test phase is taking time,” said Kullig, “and we needed a critical mass of data delivery.”

The vdp also wanted to verify that the spread indications provided were sufficiently in line, he added.

“We are still in the test phase,” he said, “but the data delivery has stabilised to the point that we have always had sufficient data to calculate an average spread, with the spread indications such that we can do so with a good conscience.”

The vdp will disclose the names of the participating banks when the secondary market data reporting initiative, in tandem with the new market-making standards, goes live – launch is targeted for the beginning of 2012 – and the median spreads will be publicly disclosed on the association’s website in Excel format.

The vdp will also monitor the quality of participating banks’ reporting of secondary market spread indications, although the data will for this purpose be rendered anonymous before being passed to committee dedicated to this task.

In addition to being relevant to a new bank liquidity framework under development at the EU level, Kullig said that the new market-making standards and secondary market data reporting project were developed with the transparency agenda set out by the Markets in Financial Instruments Directive (MiFid) in mind.

“On the one hand we are trying to bridge the gap until MiFid is implemented,” he said, “but on the other the secondary market data initiative complements MiFid in the sense that the spreads we will report are not necessarily based on trades, while MiFid is about post-trade transparency.”