Europe’s corporate secondary bond market faces a potential liquidity crisis, which requires constructive and coordinated action from all market stakeholders to find solutions, says the International Capital Market Association (ICMA).
In a study of the main causes, ICMA comments that commentators and market participants are expressing increasing concerns that the secondary markets for European bonds have become critically impaired and are no longer able to function effectively.
“This phenomenon has been widely attributed to the unintended consequences of banking regulation and extraordinary monetary policy,” the study finds. “There are broader concerns about increased market volatility, frozen capital markets, risks to economic growth and another financial crisis.”
“Liquid and efficient capital markets support economic activity, growth, and jobs.” Said Martin Scheck, ICMA’s chief executive (CEO). “It is the responsibility of market providers, investors, issuers and regulators to ensure that this vital function is not compromised’’.
Among the main findings of the study are:
- While liquidity has clearly eroded post-crisis, mainly as a result of stricter capital requirements for market-makers and unusually benign market conditions, the story is more nuanced than simply the end of liquidity. There are arguments to suggest that the levels of market depth and liquidity experienced between 2002 and 2007 were largely the result of banks mispricing balance sheet and risk, and overtrading in cash bonds being driven by the credit default swap (CDS) and structured product markets.
- Intermediaries, chiefly banks and broker-dealers, are responding by changing their models. As a result of more active capital allocation within the banks, there is a shift to holding smaller quantities of bonds in inventory, but seeking to increase turnover through smarter, more active trading on an agency basis.
- Electronification of the credit market is making an impact in Europe, and most, if not all, of ICMA’s contacts expect this trend to continue. However, while the general view is that technology has an important role to play this is still not a substitute for liquidity.
- There is a high level of concern from both intermediaries and investors regarding new regulation, not least Markets in Financial Instruments Directive (MiFID) II. While many see improved transparency as a good thing, there is a worry that too much transparency could cause market liquidity to deteriorate further. There is a suspicion that regulation confuses transparency and liquidity, which is not the same thing.
- A number of market-led solutions to the potential crisis of liquidity are discussed and analysed, including greater utilisation of e-commerce and e-trading, more developed cross-market connectivity, and changes in issuance practice. However, it is widely accepted that these initiatives cannot replace the role of market-making nor compensate for unhelpful regulation.
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