Market-making is considered integral to the ability of most financial markets to function smoothly and efficiently, with banks or their broker-dealer subsidiaries seen as performing a key role in ensuring that markets are continuous and that price discovery continues even in stressed circumstances.
However, all is not well in Market-Maker Land, as a recent report from a study group chaired by the President of the New York Federal Reserve Bank (NYFRB) makes clear, because there are signs of increasing bifurcation in markets in terms of liquidity and fragility- with participants focusing on the most liquid instruments. Interestingly, Deutsche Bank also recently announced that it was withdrawing from making markets in many developed market CDSs, to focus on areas where it believed it could generate higher returns. At Awbury, we have long argued that “liquidity” is something of a myth in many areas of the CDS market, with both size and availability in terms of execution being somewhat less than supposed. The report supports our views. In effect, broker dealers have become more like “matchmakers”, taking a client’s order and working the market to match it with one from another client, rather than taking risk onto their own book.
Obviously, legislation such as the Dodd Frank Act and the so-called Volcker Rule have caused proprietary trading by banks to decline, which appears to have had knock-on effects in areas such as the trading of corporate bonds. This is something of a paradox and a concern, given the record levels of issuance being seen, as companies take advantage of low interest rates and compressed spreads. Logically, one would expect to see larger transactions and the maintenance of bigger inventories, but the opposite is the case.
Their experience during the financial crisis appears to have reduced dealers’ risk tolerance and appetite in terms of scale, while conversely causing them selectively to seek higher risk premia; be less willing to deal in “size”; and to look more closely at the overall value of a particular business line. Of course, demand for being able to transact freely and in size has not gone away; and so-called “immediacy services” (ensuring market liquidity and aiding price discovery) are an essential part of the business models of the rising number of bond funds that promise “daily” liquidity in an environment where the reach for yield drives investors and their advisors to take more risk in terms of credit quality. A concern has to be that a “rush for the exits” will cause markets to seize up (as they have always tended to in moments of crisis or panic) at the very moment when liquidity and market-making are in most demand, a situation which may well be exacerbated by the dominance of a smaller number of very large asset managers. For example, the net bond holdings of the 20 largest asset managers comprise some 40% of their USD 23.4TN of net assets under management (AUM); while their share of the AUM of the top 300 firms rose from 50 to 60% over the decade to 2012.
At Awbury, we pay close attention to such matters, because, while we focus primarily on providing risk management solutions that are unfunded and do not expose us, or our partner (re)insurers to unexpected liquidity shocks, nevertheless, we need to understand how other market participants may behave in a crisis and the broader ramifications of such behaviour on credit quality and financial capacity.
And disruption creates opportunity.
– The Awbury Team