EU cash markets: over-broked and lack liquidity

European cash markets are over-broked, lack liquidity, and other issues for accurate pricing and capturing clients are being exacerbated by the lack of transparency, compared to the US markets, says the global co-head of flow credit trading, fixed income at Nomura in an exclusive interview with Euromoney.

“When you look at the second half of 2011, the credit derivatives market, which has a lot of visibility, did not seize up," says Nomura's Peter Duenas-Brckovich. "By contrast, the cash market, which has very poor price visibility, at certain points was broken. One reason why the secondary CDS market is bigger than the cash market is because the better level of transparency gives market participants the feeling that they are operating in a more serious and mature market.

"The cash market in Europe, unlike the one in the US, is very much an odd-lot market only. In Europe, the lack of transparency has lead to lower volumes because market participants are not confident with the price being quoted," he adds. "The latter is an important reason why the average ticket size is small. If you had a sense of the real size of the market, then one could price liquidity accordingly. This lack of visibility essentially means the ability to be able to price liquidity correctly is not available.” 

The main source of market transparency for both CDS and cash is via broker screens, but due to this, Duenas-Brckovich  says that this is fraught with issues, which make it less desirable for customers.

“An important reason why CDS prices are more credible is because it is a name give-up market – ie at the time of trade the names of both the buyer and seller must be disclosed to each other," says Duenas-Brckovich. "In the cash market, on the other hand, there is no name give-up. This latter means that the names of counterparties who, for example, paint screens with misleading information are never found out and hence their behaviour cannot be corrected.”

As detailed by the latest data from the Bank for International Settlements, global derivatives outstanding has grown since December 2010:

Anecdotally, Duenas-Brckovich estimates that secondary trading volumes (not the number of trades) in single-name CDS and iTraxx indices in EMEA are about four-times bigger than secondary cash volume.

In the US, the introduction of the US Securities and Exchange Commission's Trade Reporting and Compliance Engine (Trace), sparked frantic debates and a lot of resistance in the market. Market participants and academics argued that implementing such a system would cause a variety of shortcomings to the market, such "as confusing dealer mark-ups with commissions in measuring transactions costs and overlooking the far more relevant trading opportunity costs," says Jerry H Tempelman, author of 2009's 'Price Transparency in the US Corporate Bond Markets.

And although Trace might have facilitated price discovery, Tempelman asserts "it is at the expense of quantity discovery and, thus, has incrementally decreased market liquidity".

However, Duenas-Brckovich says this academic take on the implications for the markets does not match up with reality.

“If you look at periods when the European cash market was broken and compare that to what was happening in the US – the US cash market was functioning properly," says Duenas-Brckovich. "When US regulators introduced the Trace reporting system to the dollar cash bond market, there were some who argued it was going to be the death of the market. Although volumes and inventories have dipped, it is not because of transparency but because people are preparing for, amongst other things, the implementation of the new Volcker rules. The reality is that transparency does not seem to have affected the US market, certainly if you compare it to the European market.”

In addition, Duenas-Brckovich adds that since the implementation, it should show that, in the US, the markets have functioned properly and therefore should be adopted in Europe.

“The broad answer is that dealers think that the lack of transparency helps generate P&L, which I don’t necessarily think is the case," says Duenas-Brckovich. "The problem is that since the European market is so over-broked, dealers have grasped at straws to identify anything that gives them an edge. For some reason people still believe that poor transparency provides them with one of these edges. Historically, if you ask someone whether transparency is good or bad, most people – if they have a dominant position – will say it’s bad. In Europe, the irony is that the market is over-broked and yet it has terrible liquidity.” 

Currently in Europe,  the European Commission (EC) is revising the original Markets in Financial Instruments Directive (MiFID) that came into force in 2007. One of the key proposals for revision is increased transparency, but it mainly centres on trading activities in equity markets, including dark pools – trading volumes or liquidity that are not available on public platforms. 

The EC says "it will also introduce a new trade-transparency regime for non-equities markets [ie bonds, structured finance products and derivatives]. In addition, thanks to newly introduced requirements to gather all market data in one place, investors will have an overview of all trading activities in the EU, helping them make a more informed choice."

However, while dealers such as Duenas-Brckovich are campaigning for more transparency in the cash markets, experts are warning that without more collaboration between politicians and market participants, the industry runs the risk of implementing a new regulation or system that may work for some markets, such as equities, but cannot be replicated for certain cash markets.

“The risk that the sell-side is running is that if there isn’t some sort of collaboration to come up with a credible proposition for market transparency, politicians might opt for implementing something with little input from those who trade in that market,” says Duenas-Brckovich. “My sense is that post-crisis, there is a general push from European politicians for more transparency. In principal, that idea is good but the proof is in the implementation. If I put a politician hat on, instant reporting of all trades irrespective of size and liquidity sounds OK. However, to a dealer the latter would compromise its ability to manage risk and hence take on risk. What politicians may miss is that whilst in financial text books liquidity is taken for granted, the reality is very different for a frontline market-maker. If they are not careful, they could implement a transparency strategy that so greatly impairs a dealer’s ability to manage risk that they could kill the market."

“The lack of dealer involvement in this decision process is something I just do not understand. Considering the pressure we face from regulators, the indifference by dealers in general to the transparency issue surprises me,” he adds.