It’s hard to argue in principle against improved consumer protection, greater transparency and reduced systemic risk, but few would have anticipated the fundamental shift the latest Basel capital constraints will have on the credit market.
The upshot is that the cost of doing business in some instruments could increase dramatically – or worse, some banks will exit bond trading altogether because the numbers simply don’t add up.
In today’s world, a fixed income buy-side trader uses Bloomberg or a similar multi-dealer platform to request quotes from a number of banking counterparties that offer quotes based on their inventory and the risk they would have to assume. They also, albeit less frequently, pick up the phone to request prices from their brokers on an individual basis.
But under the Basel III global standards designed to shore up banks’ liquidity after the financial crisis, tomorrow’s world could be quite different, and both inventory and appetite for risk could be severely reduced.
Basel III will require banks to hold capital based on a different risk-weighted calculation depending on the type of instrument – corporate bonds, sovereign bonds or high-grade instruments. For more volatile or illiquid assets, banks will have to stump up more capital to offset this exposure.
So a bank that specialises in trading certain illiquid bonds could decide it is no longer economical to carry on the service.
The outcome? Wider spreads in some markets and a complete drying up of liquidity in others.
Even for more liquid products, banks will price the extra capital burden into their quotes. No prizes for guessing who the losers are in this instance.
In Europe, an additional worry is that MiFID II will bring further liquidity challenges to debt if it imposes similar transparency and reporting standards to those which already exist in the region’s equity markets.
So what’s the solution?
The changes actually present the buy-side with an opportunity to take matters into their own hands. As the holders of 90% of bond liquidity – compared to the 10% held by the dealer community – some are surprised why a buy-side-led bond trading system hasn’t already been established.
Just as Liquidnet did for equities, there is substantial opportunity for the creation of a system which lets buy-side firms negotiate prices and trade against each other.
And there is evidence such a shift is already occurring. Industry chatter suggests the dearth of bond activity means the buy-side is becoming more flexible in the way it sources liquidity, dictating the price limits it wants to trade at rather than the ‘take it or leave it’ method offered through the RFQ process. For some time, Blackrock has been thought to be preparing the launch of its own internal bond platform.
Banks are weighing their options, but many feel they are operating in a vacuum, given the lack of buy-side feedback.
With the new Basel III rules fast-approaching, buy-side firms need to talk to their brokers and make their voices heard, before it’s too late.