Traditionally liquid triple-A products, European covered bonds have not escaped the credit market turmoil.
Covered bond market-making came under scrutiny last year as secondary activity was suspended to avoid undue acceleration of spread widening. Now, as the market starts normalizing once again, players are keen to get their systems updated to avoid any further pressure on spreads.
"We kicked off 2007 with bad news that quickly snowballed into a credit crisis," a market source said. "By 2007, we started to see the banks collapse. As a result, the senior secured markets closed rapidly, but as far as the covered bond market was concerned, it was doing well."
Analysts said that it was these market-making agreements that had been supporting bond trading. However, when these bonds ended back on banks' balance sheets, it became a problem and these market-making agreements suffered as a result.
Before the credit crisis started, dealers were obliged to quote prices with a fixed bid/offer spread on a bilateral basis, a practice that could have resulted in a lack of price transparency, according to the European Covered Bonds Council (ECBS). The ECBS is a platform for covered bond market participants that brings together covered bond issuers, analysts, investment bankers, ratings agencies and a wide range of market participants.
If the liquidity levels in certain bonds were to fall, a discrepancy could emerge between the price quoted on electronic trading systems and the price dealers quote each other. Furthermore, market makers could quote an artificially wide bid to avoid excess risk and, as a result of the fixed nature of the bid/offer spread, the offer could move in line. This could send spreads wider and suspend inter-dealer market making.
Some argue that interbank market making was never designed for products that would widen so significantly in such a short period of time. As a result, the ECBS created its 8-to-8 committee to implement changes to the covered bond market-making system so it could combat the spiral of price widening and improve covered bond trading. The 8-to-8 committee recommended that interdealer market makers commit to a maximum of double the normal market-making bid-offer spread on a minimum amount of 15 million ($21.9 million).
"This worked for a bit, but the whole thing has gone into a spiral again and we are realizing that the best way forward is to tier the market," said Derry Hubbard, head of covered bond marketing and execution at BNP Paribas.
As a result, Hubbard said the committee now accepts that for certain transactions trading at a bid spread of 20 basis points over Euribor or above, there may be a need to vary the recommended bid/offer spreads and sizes quoted between market makers. This adjustment should be no more than three times the normal bid/offer for a size of 5 million to ensure that orderly and transparent markets are maintained.
The ECBC is also looking to tweak its electronic trading platform that already exists and make it more efficient. "As bid offers widen, volume hasn't gone down, and this volatility should create trading opportunity," a market source said.
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