Covered bonds’ status in Liquidity Coverage Ratios, a potential paradigm shift stemming from MiFID, and the fate of the jumbo concept in the ECB’s collateral framework — inter-dealer market-making may be dead, but liquidity is very much a live issue. Neil Day reports.

Even though the European Banking Authority may have chosen to ignore its own findings on the liquidity of covered bonds when it recommended against their inclusion as Level 1 assets under CRD IV, the conclusion of its analysis of the relative liquidity of various asset classes nevertheless remains: covered bonds rank behind only government bonds when measured on various liquidity-related metrics.

This may not be enough for covered bonds to achieve their goal of top status under the European Union version of Basel III, but it comes as a timely reminder of the asset class’s credentials — particularly given that it is a topic that at the onset of the crisis in 2007 proved the most controversial of all for covered bonds.

“We beat ourselves up as an industry about not being able to give six cent bid/ask spreads,” says Richard Kemmish, chairman of the European Covered Bond Council (ECBC) market-related issues working group and covered bond consultant, “but the reality is that compared with unsecured debt or the securitisation market or whatever else you care to compare it with, it wasn’t that bad.

“We try to be silly sometimes and compare ourselves with liquidity in the BTP market, for example, or to live up to unrealistic expectations.”

However, others are still quick to point out how much things have changed since pre-2007 when the long-established and much vaunted inter-dealer market-making system was in place. “Not by any stretch of the imagination,” says one market participant when asked whether liquidity today can be in any way likened to the situation pre-crisis.

Michal Klestinec, senior portfolio manager at the National Bank of Slovakia, also contrasts the situation now with the days when tickets of Eu50m were easily traded at tight bid/offer spreads.

“Now if you ask someone if they can offer you Eu5m or Eu10m, sometimes it’s a problem,” he says. “The easiest way we can trade these days is to have a very good connection to three or four investment banks and you tell them what your plans are so it is easier for them to get the bonds for you. But this is something that you cannot do with everyone, so some are happy, some aren’t.

“I definitely don’t use brokers,” he adds, “because once you give an order to them to buy something for you the price can be destroyed — and that is something I can do on my own by asking 25 banks. So frankly you have to be very cautious and selective when asking someone to offer you bonds.”

Klestinec says that the draining of liquidity from the market has been exacerbated by the lack of supply and tight levels in covered bonds, in turn resulting from the deleveraging of the banking system and the provision of liquidity to it by the European Central Bank via its LTROs.

In parallel to this, Gabriele Frediani, head of markets at MTS, which runs electronic trading platforms, highlights how the deleveraging of banks has led to a reduction in banks’ activity in the secondary covered bond market.

“The fact of the matter is — and this is probably our selling point — that in the area of liquidity provision there are fewer players,” he says. “In these markets that function or that have traditionally functioned by the sell-side providing liquidity to the buy-side, if the sell-side has, say, a showroom of 100 cars and there are 10 of them, then that’s 1,000 cars.

“But if the balance sheet available means that my showroom can now only take 25, and on top of that there are only five players left, then ultimately the market is smaller if nothing is done to recycle the inventory faster and more efficiently.”

MiFID looming

Since the onset of the crisis the European Covered Bond Council has engaged in various initiatives to try to improve secondary market conditions. When market-making first broke down it created an “Eight-to-eight” committee comprising market-makers and issuers that could recommend changes to standards, but it gradually moved towards looking at longer term solutions to the problem. However, despite market participants, trading platforms and others having tested various new standards and systems over the past few years, no concrete proposals are on the table.

Luca Bertalot, head of the ECBC, says the industry body remains engaged on the issue.

“The secondary market is a complex issue and we have to involve several stakeholders,” he says. “But at this stage we are coming out of a crisis and there is not yet the proper balance necessary to tackle secondary market liquidity for the longer term.

“The entire banking system is changing, the economy is going through important changes, and per se the covered bond market also has to adapt to this new environment. All stakeholders will really have to rethink the market and there is a role for the ECBC as a forum for discussion in this.”

What could force the industry’s hand is MiFID II, the new Markets in Financial Instruments Directive. With an overarching philosophy of moving trading in financial instruments from over-the-counter markets to exchanges, the regulatory initiative has had the potential to cause a paradigm shift in the functioning of fixed income markets.

And a focus on requiring pre- and post-trade transparency has caused consternation among traders in the covered bond market.

“MiFID quite rightly thinks it is a little bit of a closed shop, that there is differential access to information in the covered bond markets,” says a market participant. “The traders of course say, well, yes, that’s legitimate, because we are committed to this market, committing balance sheet and traders, and the informational asymmetry is the quid pro quo for that commitment.”

Traders have also argued that revealing too much information about trades too soon could hit prices and prevent them from being able to serve investors’ interests, while the practicality of pre-trade transparency — whereby prices would have to be shown to a much wider range of market participants, are unworkable for them.

However, Kemmish argues that there has been too much reluctance to engage with the regulatory initiative, with the risk that unwelcome regulations are more likely to be imposed given that the industry has not put forward a compromise position. This could, for example, mean having a limit on the size of trades that need to be reported and a delay in reporting.

Fortunately, as Sascha Kullig, head of capital markets at the Association of German Pfandbrief Banks (vdp), says, the latest version of MiFID has dropped some of the most potentially damaging aspects of earlier drafts. However, he says that — partly because many details are yet to be worked out, such as the size of trades to which the requirements will apply — it is far from clear what the impact of MiFID will be.

“That’s the million dollar question,” he says.

The direction of travel regarding market regulation is nevertheless towards a world of greater transparency, and Kemmish argues that the electronic trading platforms are well positioned for this.

“What EuroMTS, Eurex, TradeWeb and all those people do is provide better pre-trade price transparency, i.e. you can look at a screen and see a meaningful price that you can actually trade,” he says. “Not necessarily the best price — that’s only still for the privileged elite of market-makers — but you can see a price to value your bond.”

Connected to MiFID, but launched independently of the regulatory move, has been the vdp’s own secondary market initiative, which was launched in January 2012. Under this, the association publishes daily prices for more than 100 Pfandbriefe based on the average levels submitted by banks, after having expanded the initiative to take in benchmarks of Eu500m or larger rather than just jumbos of Eu1bn or more at the beginning of 2013.

A question of definition

The ECBC has, meanwhile, been engaged on the issue of liquidity with regards to the European Banking Authority’s considerations and ultimately the European Commission’s decision — due by the end of June — on the fate of covered bonds in liquidity buffers under CRD IV. And Bertalot and others are quick to differentiate the concept of liquidity in this context from ideas relating to secondary market liquidity.

“There’s always the question of what you mean by liquidity,” says Kemmish. “Is it empirical, how many times these bonds actually trade? In which case, it probably isn’t fair to call covered bonds particularly liquid compared with other markets.

“Is it, can you get a bid when you need one? This is what the regulators mean when they are defining eligible assets for LCR. And, yes, in covered bonds, you absolutely can.”

Another market participant echoes this.

“The definition of liquidity must be based on: will you always get a bid?” he says. “There is a problem with any backward-looking definition of liquidity, because a bond might have been liquid for many, many years, but if something in particular happens then it might become illiquid immediately. So having had a liquid market in the past doesn’t mean that you will be able to sell your bond in a stressed situation.

“We discussed this topic with some regulators and they understand this point of view, but on the other hand they say that they can’t rely on this definition, being able to get a bid, because you don’t know if you will be able to get a bid, so how can they base requirements on such an expectation? It doesn’t work.”

ECB: the final jumbo frontier?

With the death of traditional inter-dealer market-making and the minimum size threshold for inclusion in key indices such as iBoxx, one of the last bastions of the concept of a “jumbo” covered bond is the European Central Bank’s repo framework, where the format enjoys a lower haircut than other covered bonds. Some market participants believe that this should also be rethought.

Investors are more relaxed than in the past about a clear distinction between deals of Eu1bn or larger and anything smaller — with Eu500m typically being the new smaller standard, which is sometimes dubbed jumbolino — but they argue that a correlation between size and liquidity remains.

“If you have a jumbolino issue, it is quite often parked with ALM or treasuries and they keep the bond until it’s like money market paper,” says Klestinec at the National Bank of Slovakia. “Ideally, the bigger the deal, the bigger the flows.”

However, he says that it shouldn’t be the case that only the size of deals — whether they are Eu500m or Eu1bn — that should lead to higher or lower haircuts, as it should be a combination of both the size and the credit quality of the security.

A Frankfurt-based covered bond investor takes a similar stance.

“Well obviously size matters,” he says. “I wouldn’t dare to say that it is completely irrelevant whether you have a Eu500m bond or, let’s say, a Eu3bn bond.

“So yes, it does matter, but it is not a perfect correlation. It is not directly proportional, to be honest.”

However, while acknowledging this — and also that the ECB has had more pressing matters to consider — he is not convinced that the jumbo distinction should retain its place in the central bank’s collateral framework — returning to the question of what liquidity means.

“The question is, what liquidity are you looking at?” he says. “Maybe the pricing signals you receive over time may be weaker in the smaller bonds than in the larger ones. But it shouldn’t be a problem from the ECB perspective if you have something like that as collateral — if their debtor goes bust they get the collateral and then they have to sell it in order to make the loan good.

“In this case, the ECB just has to care whether there is a bid out there, and I think the bid these days definitely is out there.”

Kullig at the vdp points out that the ECB’s jumbo classification is more than simply a size threshold.

“We still have the market-making requirement,” he says, “so it’s not just Eu1bn, it’s also the requirement that it is traded on an exchange, and the second requirement is that you have at least five market-makers, and the ECB also requires at least three market-makers, so there are still some more requirements than just the volume of issuance.

“Of course the question is what market-making mean these days,” adds Kullig. “It’s more or less the obligation to quote if the investor asks for a quote.”

Some market participants are nevertheless sceptical about whether this new concept of market-making is deserving of the special treatment that the traditional version previously merited.

“Frankly, the concept of the jumbo has disappeared in the way that there is no more market-making,” says an investor.

Kullig meanwhile says that the vdp is open to the size criterion being changed.

“You can certainly discuss whether the Eu1bn level is justified or not,” he says, “but then I think a fair step would be to reduce the volume to Eu500m, because in Germany at least, but also in other countries, you have more or less the same criteria that apply to jumbos applying to benchmarks, too, with at least three or five market makers.

“So we would be in favour of reducing this issuance size. But eliminating it completely, I think this would be a mistake.”

The Frankfurt-based investor says that the focus for the ECB should rather be on the security of the instrument.

“In terms of the safety and rating,” he says, “it is the same cover pool, and if you issue a Eu500m or a Eu1bn bond against the same pool, and same issuer and all the mechanics and the same legislation and so on and so forth, it doesn’t make much of a difference. So if worst comes to worst, and the bank delivering the paper goes bust and the covered bond goes bust, then you have the same recovery on those bonds.”

The ECBC has promoted the idea of the Covered Bond Label replacing the jumbo concept as a prerequisite for preferential covered bond treatment within the ECB’s collateral framework.

“Nowadays we have a definition that is exclusively a size definition, I would argue,” says Bertalot, “which is not a definition at all. At the same time, the industry has made an effort to harmonise a set of parameters that are not only about size, but mainly relate to credit quality, with CRR compliance and transparency, and are aimed at harmonising best practice.”

Kemmish agrees the Label would be a sensible replacement.

“Why? Because homogeneity creates liquidity, more than you might normally expect, given the details of any given bond” he says.

He says that the reason market-making worked so well before the crisis and that traders could quote tight spreads for larger ticket sizes was that hedging was made easy by the correlation between, say, German Pfandbriefe.

“So if I wanted to go short Eu50m of a Eurohypo 2018, I’d go long a HypEssen 2018, and they were so heavily correlated that I could take on that position,” says Kemmish. “But when credit became an issue, when everything started kicking off, obviously that broke down and the correlation between price moves became worse and worse. Of course there are still some credit concerns, but for the majority of investors trying to get their head around this very fragmented market, the idea of some degree of homogeneity in the product clearly increases correlation, and the more you increase correlation between price moves, the more you have an ability to hedge positions, and therefore take on positions as a trader.

“People who aren’t necessarily that au fait with the product but who know it’s a good thing, they get a lot of reassurance by the Label, by that branding saying these meet certain standards.”

Although some market participants play down the importance of the whole issue of the jumbo’s position in the ECB’s repo framework — particularly given how well-treated covered bonds are in general, and how their lot has improved — others argue that the impending decision on the position of covered bonds in Liquidity Coverage Ratios under CRD IV by the European Commission by the end of June makes the debate all the more important.

“To some extent liquidity becomes a self-fulfilling prophecy, if you are Level 1, you are going to be more liquid than a Level 2 product,” says Kemmish. “To the extent that the Commission clearly likes what it sees with the Label, it increases the probability of covered bonds either individually or generically becoming part of a higher liquidity category, which becomes self-fulfilling.”

“And Commission will obviously have to take into account the ECB repo rules,” he adds.

However, many market participants, not least in Germany, remain sceptical about the added value of the Label as a quality mark that could or should justify preferential treatment — a discussion too long to go into here.

But Kullig at the vdp also points out that the Label makes no reference at all to size — which, as above, has been cited as a continued contributor to liquidity — or at least some definitions of it.

“To my knowledge, the Label is not linked to the issuance size,” says Kullig. “And if it doesn’t matter if the issue size is Eu1m or Eu1bn, then even registered covered bonds can be labelled — and by definition registered bonds are not ECB repo-eligible at all.”