Primary dealers profit from ‘destroying their own credits’

Use of private placements to fill engineered shorts distort government bond market

In volatile markets, opportunities arise and the government bond market is no different. A select number of primary dealers – banks with preferential access to sovereign bonds – have been taking advantage of a lack of liquidity to dictate the prices of certain bonds and then reaping the rewards with outsized trading profits, squeezing out other banks and investors.

Some large primary dealers in the European government bond market have been building short positions across specific bonds and raking in trading profits when these positions are closed through private placements issued by sovereigns under terms set by the banks. The shorting of these bonds artificially creates demand due to the cheapness of the curve. This triggers interest from real money investors to tap up the dealers who ask the treasury for a private placement – closing the short position of the dealers at a price beneficial to them.

According to insiders, the largest primary dealers are raking in profits at levels unheard of over the last few years due to these trades. On a €500m short, a bank can easily take in €5m-€10m of profits, according to a market official with knowledge of the matter. But the profits are not the only concern. The practice also leads to the distortion of price discovery in these bonds. ‘There’s a complete lack of price discovery,’ said a portfolio manager at a leading US asset management firm. ‘It makes me want to reduce my allocation and involvement in these sovereigns. If certain banks control so much volume, they can set the price at whatever they want. It’s not a fair game. They’re destroying their own credits.’ The investor continued, saying that the practice is becoming more commonplace, with one infrequent sovereign increasing its volume of private placements to a level representing 30% of its gross supply over the past year.

This distortion can have consequential effects in the performance of syndications if real money investors simply give up on certain sovereigns and decide to not participate in the public sales of bonds by these issuers. The order books are largely filled with fast money accounts, leading to bonds underperforming in the secondary market.

It is understood that this is a feature of only the smaller and less liquid European government bond markets where there are just a handful of banks controlling almost the entire market for those issuers. Arguably, this is an inefficiency in that it allows a few banks to be the end-price-setters rather than the market. This concentration of the primary dealership model – mostly by banks with bigger balance sheets – also risks squeezing out smaller banks who simply cannot compete with the capacity and risk limits of the larger dealers who can afford to build up substantial short positions on specific bonds.

A portfolio manager at a global investment manager said: ‘Primary dealers have a special advantage in that they can be short a bond and instead of scouring the market to find an alternative, they can just go to the DMO [debt management office] to fill their short through a private placement.’

The portfolio manager described the current short positions by dealers as ‘special access pronounced by market conditions’. Banks are particularly keen on being short in the front end of the curve to benefit from rising yields due to interest rate hikes by central banks. The banks would argue that they are not breaking any rules and need to monetise their commitments to being a primary dealer – which, for many, is often a loss-making enterprise.

What is the solution? One idea is for sovereign DMOs to enforce their primary dealers to report on their entire positions of every bond. They can do this daily. This would disincentivise the short positions being created by banks and thereby creating a more level playing field. But this is hard to manage due to the structural system of the government bond market. Banks know that the treasury is a seller of last resort. That encourages the market to be short and cheapen the credit as it is guaranteed to bring in returns. There will always be an uneven playing field to some extent as banks need incentives to be primary dealers and their role is essential to the functioning of the government bond market. It is hard to see how that changes.

Burhan Khadbai is Head of Content of the Sovereign Debt Institute at OMFIF.

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