Financial Reform and Sovereign Debt Markets...sovereign bonds Structural reforms of banks unintentionally discourage market making and intentionally limit proprietary trading, one

Financial Reform and Sovereign Debt Markets

Anne Leclercq

March 2015

Belgian Debt Agency

Kingdom of Belgium | Federal Public Service FINANCE | Treasury | Belgian Debt Agency | Avenue des Arts 30, B-1040-Brussels www.debtagency.be

Some Key Global Reforms

Regulations as a response to the crisis increasing the stability of the financial sector

Basel III

EU banking Union

Structural reforms in banking

FTT

Regulations wrt specific markets or instruments MiFID

EMIR

Regulations affecting some classes of investors Solvency II


Sovereign in financial markets ?

Sovereigns in financial markets are multi-faceted entities and operate :

As market participant : Hedging in derivatives markets

Cash management in repo markets

As borrower : PM : Issuer of benchmark bonds channeled via PD

SM : Low return - high liquidity Market making by PD

As “savior” of systemic banks : More resilient banking sector

Banking Union : creation of an efficient crisis management framework


Conflict of interest ?

Sovereigns have a vested interest in healthier banks improves risk profile of the sovereign

Sovereigns have equally a vested interest in preserving liquid bond markets

main attraction point of the low yielding bonds

reduces funding cost for sovereign borrowers

Impact of rules on functioning of markets is not always well understood by rule makers

role for markets and debt managers to inform


Impact of regulations ?

Impact in 1st degree :Sovereign as market participant

Derivatives : EMIRSovereigns are exempted from mandatory use of CCP’s for derivatives BUTpossible higher cost due to influence of regulation on counterparties

Cash management : RepoAvailability of underlying sovereign bond is collateral “par excellence”

change in rules of collateral usage

NSFR : Questions can be asked on the equal treatment of secured and unsecured lending ?


Impact of regulations ?

Impact in 2nd degree : Sovereign as borrower

Current business model

PM : auctioned or syndicated Bonds are channeled to investors via banks

SM : Liquidity is provided via market making

Three main components of PD business model

Investor base and regulation

Warehousing of low yielding bonds

Liquidity of repo markets and secondary markets


Impact of regulations ? Investors

LCR - Liquidity Coverage Ratio enducesholdings of sovereign debt

Bank treasuries have become captive buyers

Catalyst in post crisis recovery of PM

BUT

Influence on smaller markets ?

Will decreased availability of bonds make funding of government securities more expensive

Solvency II

Capital charge to be added for experienced volatility

Concentration risk in portfolio


Impact of regulations ? Warehousing

Capital structure : 3 dimensional capital target

1. Total Capital ratio

2. Minimum Equity Tier 1 Capital Ratiopossible changes in risk weighting of the asset base

3. Leverage Ratio BINDING ???fully loaded asset base + add-ons

discourages low-risk/low yield asset holdings


Impact of regulations ? Warehousing

Conflict

As Savior need for deleveraging –strong capital structure

As Borrower confronted with decreased dealer inventories

Possible IMPACTHigher capital requirements and changes in the asset base calculations raises the cost of holding inventory by the dealers

Lower dealer inventories and less frequent trading should

widen bid/ask spreads

increase volatility


Impact of regulations ? SM Liquidity

Repo market

GLUE in the sovereign debt markets

At the crossroad of various regulations

EMIR : increased collateral requirements

Leverage ratio : calculation in the asset base

LCR : availability of bonds

NSFR


Impact of regulations ? SM Liquidity

MiFID Aim improve market transparency

Market structure : SM liquidity is provided by Market Makers – role of various market participants

Pre- and Post-trade transparency :if un-calibrated will adversely affect the liquidity and the cost of sovereign bonds

Structural reforms of banks unintentionally discourage market making and intentionally limit

proprietary trading, one source of liquidity

definition of market making in commercial banks

reforms might increase market volatility through the introduction of

new barriers between stability provided by access to deposits and financial markets.


Conclusions

Likely effects on markets

Overall, global financial reforms concentrated on making finance and national economies substantially safer and more stable…

but many measures will reduce market liquidity and few will enhance it …

All else equal, higher capital and other costs, less inventory and reduced trading should :

widen bid/ask spreads

increase volatility

reduce the yield benefit investors give GBs for their liquidity

reduce the value of current holdings of government bonds

Hence influence the cost of funding for sovereignsKingdom of Belgium | Federal Public Service FINANCE | Treasury | Belgian Debt Agency | Avenue des Arts 30, B-1040-Brussels www.debtagency.be

Conclusions

However 2 observations

1. Mostly this has not happened yet

Substantial amounts of cash and the related search for yield combined with a lack of alternative investments and a continuous need for liquid bonds …

have created a very benign environment for liquidity and volatility

Even though market participants tend to lead regulatory timing

core capital increased

LCR requirements fulfilled


Conclusions

Statistics

Before QE liquidity metrics did not reveal major changes in volumes traded …

But QE start creates uncertainty and slightly impacts volumes


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turn

over

bill

ion e

uro

Inter Dealer Customer

Conclusions

Statistics

Turnover ratio =

Traded volume

divided by

outstanding debt

(source : BIS)


Conclusions

Statistics

Before QE liquidity metrics did not reveal major changes in

bid-offer spreads …

But QE start impacts spreads even though NCB buying is still limited


Conclusions

● But markets are experiencing increased volatility …

Which will even more accentuated by the effects of QE


Conclusions

2. Very likely major sovereign markets will less be affected by the structural reforms

There will always be a strong natural demand for sound sovereign credits

Further fragmentation of EA sovereign debt markets as smaller markets will suffer more

Reduction in liquidity in very short term bonds

Regulations are likely to be modified to some extent if the effect on major markets and economies is too large

but the combination of structural reforms and QE will noticeably impact the liquidity

but can the effect can be tempered by efficient securities lending


Conclusions

Potential adaptive responses

Sovereign might wish to mitigate effect by reflecting on

Adapting the PD business model so as to continue to make PD-ship attractive

Changing issuance policies – frequency and size of issues

Changing PD business model

Non-bank actors escape mostly the negative effects of the rules and will partially fill the liquidity gaps

In the mean while continue to inform rule makers


Conclusions

“It is a mistake to try to look too far ahead.

The chain of destiny can only be grasped

one link at a time”

Winston Churchill


Documents

Financial Reform and Sovereign Debt Markets...sovereign bonds Structural reforms of banks unintentionally discourage market making and intentionally limit proprietary trading, one