The idea of hedge funds playing a more active role in government bond markets is not novel. In the US Treasury market, for instance, hedge funds are becoming increasingly more involved in market-making activities as traditional banks have pulled back due to heavy regulation since the 2008 financial crisis. However, allowing hedge funds to join investment banks with preferential access as official dealers is a step further and an idea worth exploring.
Over the years, the words ‘unsustainable’ and ‘primary dealerships’ have almost become synonymous of each other. This is in relation to how they describe the steep costs investment banks face with the various commitments and obligations of trading and managing sovereign debt in Europe. It is not just costs but also the balance sheet constraints of banks limiting the liquidity provisions and risk-taking capacities they can make.
This is where hedge funds are brought into view. While they are financial institutions, they are not subject to the same heavy regulation and leverage limits as banks. This means they can take on more risk in trading and warehousing bonds, which is what hedge funds have been doing in the US Treasury market. In some cases, this also happens in Europe in roles that are unofficially known as ‘shadow dealers’ – where primary dealers tap up hedge funds as a way of facilitating risk.
Key liquidity providers
In addition to the greater risk-taking capacities of hedge funds, the other key argument for allowing hedge funds to be primary dealers is that they are key liquidity providers. You only have to look at the role hedge funds play in secondary markets for evidence of this. As they are crucial in the performance of European government bonds, allocations to hedge funds in syndicated transactions are therefore key.
‘Similarly to other European government bond markets, hedge funds play a very important role in the Spanish public debt market, providing liquidity across the curve,’ said Mercedes Abascal Rojo, head of funding and debt management at the Spanish Treasury. ‘Far from falling, their role has been increasing in recent years and we have frequent conversations with these investors.’
Hedge funds argue that they have a sharp eye for real demand, which helps the performance of bonds in secondary markets. A sovereign portfolio manager at one of the largest US-based hedge funds argues that allowing hedge funds to have access to primary markets would bring new issue premiums down due to their having a thorough understanding of where real demand is.
Having just banks as sellers limits the scope of finding real demand, according to the portfolio manager. Hedge funds also argue that banks only pitch to their own investors and for their own interests, such as to close short positions via private placements.
Too many obligations?
There is scepticism, however, on whether hedge funds can keep up with the obligations of being a primary dealer.
‘I don’t think it works,’ said a senior debt capital markets banker. ‘Primary dealerships are tied to so many obligations and requirements that many hedge funds would not find them fulfillable,’ he said. ‘There are obligations to take down bonds, make markets, reporting obligations and investor marketing.’
This view is shared by many senior officials at sovereign debt management offices. ‘To become a primary dealer, one must comply with specific requirements in quoting and trading activity as well as obligations with the placement and diffusion,’ said Rojo. ‘All these requirements could make for a hedge fund to be constrained by too many limitations and can, in essence, harm their business. Nevertheless, the Spanish Treasury believes that hedge funds are important to create liquidity, so their presence in debt markets is desirable.’
All European sovereign primary dealerships have various commitments and obligations. However, some have lower barriers than others. Germany’s Finanzagentur is the exception where there are zero obligations.
Another issue is that hedge funds are notorious for being volatile players that take on a lot of risk. Can they be trusted to be more consistent providers of liquidity?
‘I’m quite reluctant that they can behave like an ordinary primary dealer in terms of providing liquidity at any given time and under any market conditions,’ said Davide Iacovoni, director general of public debt at Italy’s ministry of economy and finance. ‘It’s true that hedge funds have become a different animal over the last few years in the capacity of providing liquidity. But these are new liquidity providers. Can DMOs rely on them? It’s something to analyse.’
The volatile nature of hedge funds is something that is a particular cause for concern for DMOs.
‘If hedge funds become primary dealers, it would pose different challenges for all treasuries,’ said Rojo. ‘First, hedge fund activity is characterised for being riskier and more complex than that of other financial institutions,’ she said. ‘Ultimately, this means more volatility in public debt markets and one of the main duties of a primary dealer is to maintain stability in markets.’
To counter these points, no one – not even hedge funds themselves – are proposing to replace banks altogether. The idea is to allow them to have access to primary markets alongside banks. But how such a model would work? Although the US has loosened the criteria for a primary dealer, only financial institutions with a banking licence can hold such roles in Europe.
This is obviously a big hurdle. Perhaps the first step would be to allow hedge funds to have more access and a greater role in market-making for European government bonds. ‘Having hedge funds involved in market-making will help liquidity,’ said a senior DCM banker. ‘The question is how you structure it and what platform you use. I don’t think people would be keen to have it on an inter-dealer platform so it will have to take place on another platform.’
There are many things to consider if this will take off. But most importantly, sovereign DMOs will have to tread carefully between looking for ways to improve the sustainability of primary dealerships and the liquidity of their bonds, while ensuring they do not dilute the advantages and incentives for banks to remain committed to this market.
OMFIF’s Sovereign Debt Institute will be discussing ways to improve the primary dealership model and liquidity at the 2024 Public sector debt summit on 21 March in Paris. Click here for more details and to register your place at the event.
Burhan Khadbai is Head of Content, Sovereign Debt Institute, OMFIF.