The past 30 years is the blink of an eye in the long history of government debt, but western European sovereign debt markets have changed beyond recognition, and it has been a turbulent journey.
The biggest change has to be that western European markets now largely operate in the same currency, though the resilience of that currency has been sorely tried in recent years. Governments that saw yields plunge with the introduction of the euro, and grew used to borrowing at triple-A levels in the 2000s, had the door to the debt markets slammed in their faces, and had to confront IMF programmes and junk-rated status.
Central banks in the eurozone and the UK are once again an essential part of the market, not now as debt managers, but as the largest investors in government debt, through QE programmes which have drained liquidity and collateral out of the secondary markets.
The primary dealership model which has served markets for more than 20 years is, more than ever, in question, with regulation squeezing bank balance sheets, and forcing dealers to focus on returns.
Today’s debt management still owes a lot to the late 1980s and the 1990s, at least in its philosophy, as most western European countries established an independent DMO, and an independent central bank, often in tandem with a broader deregulation of financial markets.
The UK, for example, established its primary dealership status in 1986, and smartened up its debt management further a decade later, creating the Debt Management Office, and making the Bank of England independent.
“Markets would charge a risk premium if debt management was perceived to be influenced by ‘inside information’ on interest rate decisions,” says Robert Stheeman, chief executive of the UK DMO.
“That’s not to say that this would have happened had the Bank retained responsibility for monetary policy, but setting up a new agent with the ability to issue debt separate from the body which sets interest rates was designed to avoid the perception of a conflict of interest.”
France set up its Agence France Trésor the same year, while others also modernised. Spain still runs its debt management from within its treasury organization, but 30 years ago it scrapped physical paper settlement, established a primary dealer system in 1991 and central bank independence from 1994. Ireland also stepped up, moving from agency broking to a panel of market-makers taking principal risk.
“Under the agency model that applied in Ireland at the time, dealers earned commission from matching buyers and sellers and, naturally, there was little incentive to move to a more risk-based, market making model,” says Frank O’Connor, director of funding and debt management at Ireland’s National Treasury Management Agency in Dublin. “However, Ireland was out of step with the wider market in that respect and that informed the NTMA’s move towards market making.”
Together at last
The founder countries of the eurozone had a further reason to up their game and set their central banks free — convergence into the euro, with managed exchange rates, and the growth of the Ecu.
After the currency was established interest rates in Europe’s higher yielding countries dropped sharply, and the investor base for sovereign debt ballooned.
“One of the most immediate consequences of the introduction of the euro was a strong reduction in interest rates which also led to a reduction in spreads among the different members of the euro until the financial crisis in 2007,” says Pablo de Ramón-Laca Clausen, deputy head of funding at the Spanish treasury.
The now-independent DMOs and their primary dealer panels had economies and budget surpluses, and the space to work on optimising debt. Countries began to focus on concentrating liquidity into benchmarks, and attracting investors from across the eurozone.
“The move to the euro meant we lost some of our domestic buyer base, since they were now able to explore euro denominated investments across the currency area, but overall we gained a larger suite of new investors,” says O’Connor.
“We already had some foreign investors and some foreign currency debt, but the euro meant we had a substantially expanded universe of potential buyers. Allied to this, we had to step up our communication and spend more time explaining Ireland and the market in more places and that proactive, joined-up communications approach remains a central part of our strategy today.”
The pressure on primary dealers has been a constant refrain, since the system was established — DMOs need to encourage dealers to purchase their debt and contribute prices but make sure they get value for taxpayers.
“We’re not trying to make GEMM status unnecessarily onerous,” says Stheeman. “We cannot force banks to be GEMMs and we cannot force a market to exist. But we can encourage the GEMMs to contribute genuine price-forming information through bidding on — not winning — 5% of the auction amount on a rolling six-month basis.”
All DMOs with the exception of Germany have to balance the stick of taking down auctions with the carrot of syndication fees, special repo facilities and other privileges, but the re-regulation of the banks following the crisis has put pressure on this delicate balancing act.
“Changing regulation is impacting primary dealers, particularly their ability to take risk and hold positions of reasonable size,” says O’Connor. “This is leading to some degree of market consolidation. However, our own experience is that we continue to have a very competitive primary dealer network.”
Credit Suisse and RBC, in recent years, have scrapped all of their primary dealerships in Europe, while Deutsche Bank has withdrawn from Belgium, and Crédit Agricole from Ireland and Austria.
For even the strongest sovereigns, the financial crisis of 2008-2009 and the sovereign crisis which followed were troubled times and led to big changes in how they approach their government bond markets.
Economic downturn, bank bailouts and, for some, limited market access, meant DMOs had to use new debt management techniques, and issue new instruments. Most sovereigns issued longer debt whenever they could, and far more of it.
“In 2009-2010 when we started the regular programme of syndications, it was in part because of the sheer size of the borrowing programme,” says Stheeman. “But it has a series of other advantages – including giving certainty to the market that we can supply additional amounts of long and ultra-long conventional and index-linked issuance, and thereby mitigate refinancing risk.”
The syndication programme became a regular part of the market, but the UK, with its own currency, and a QE programme from 2009, had far less to worry about than the eurozone periphery.
The biggest buyers
The saviour of those eurozone sovereigns was Mario Draghi’s commitment to do “whatever it takes” to save the euro in 2012. Fixing the single currency is still not quite a done deal, with periodic flare-ups in Greece and dark mutterings about the Italian banking system, but the ECB showed that it meant business when it started buying government bonds in 2015.
Monetary policy and debt management remained formally separate, but in practice, the national central banks of the eurozone were the biggest buyers of bonds, and investors had to cope with core markets offering negative yields.
“The Eurosystem’s PSPP presents sovereigns with the challenge of retaining and deepening its private-sector investor base,” says Ramon-Laca Clausen, noting that non-resident non-eurosystem holdings of Spanish debt were around 50% of the total.
The ECB may start to unwind its participation in markets this year, but its activities have already starved collateral markets of supply, leading to collateral crunches at the end of each quarter, as banks and investors dress balance sheets for reporting season and hoard liquidity.
Looking at the US government market, however, the deepest, most liquid capital market in the world — and the source of most innovations — an unlikely liquidity saviour could be at hand, in the form of the non-banks, who could bring about a step-change in sovereign debt trading.
The likes of Knight Capital, Virtu and Citadel Securities are running systematic or automated trading operations, offering tighter bid-offers in smaller size than some of their bank competitors, while more investors are opting to access Treasury auctions directly, rather than through the existing US primary dealer system.
Europe’s fragmented government bond markets offer a smaller field for these players to ply their trade, but they’re definitely interested. More liquidity has been migrating to electronic platforms, while the related markets of interest rate swaps and bond futures are fast becoming standardised, cleared products. The next 30 years will surely see the robots finally take over.
