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* Regulatory pressures squeeze sovereign bond trading
* RBC tests new supra and agency-focused strategy
* Rivals question ability of bank to hold on to key clients
By John Geddie and Christopher Whittall
LONDON, Aug 9 (IFR) - More banks could be poised to follow RBC and exit unprofitable European government market-making, removing a valuable source of liquidity in these markets and potentially hiking borrowing costs for some sovereigns.
Banks' sovereign businesses are buckling under the weight of a regulatory squeeze on trading book capital and the prohibitive costs associated with primary dealerships.
The Canadian bank unexpectedly culled its European government coverage in late July, and could well be a trailblazer for others looking to maximise profits if it can continue to win mandates with its remaining supranational and agency clients.
"It's possible other banks will exit government bond trading. The return on equity on this business is very challenging right now because of the capital requirements on trading books and other regulatory developments, not to mention other costs associated with being a primary dealer," said Elie El Hayek, global head of interest rate trading at HSBC.
"We've already seen that starting in smaller countries where banks will exit first, reducing the liquidity of their bond markets and increasing their funding costs."
Sovereign bond trading has long been seen as imperative for a successful fixed-income franchise, not least to win syndicated and other ancillary business from countries' debt management offices, but also because many large funds and central banks have traditionally only transacted with primary dealers.
Debt managers, especially at smaller sovereigns, have regularly seen investment banks join and then leave primary dealerships, but new regulations could increase this churn as they try to find the right model.
RBC was not the first bank to re-evaluate its sovereign business when it exited Belgium, Italy, France, Germany and Spain and reallocated those resources towards the fee-paying sub-sovereign business supranational and agency franchise.
"We have all learnt during the crisis that it is important to do what you do best, and do it well, not just to be average in a lot of things," said Jonathan Hunter, global head of fixed-income and currencies at RBC.
Other houses have been selectively ducking out of dealerships over the past year. BNP Paribas, for example, left the Netherlands at the end of 2012, while UBS exited Austria as part of its scale-back in fixed income in October.
Primary dealership duties such as bidding at auctions are already costly, while regulation is squeezing margins on secondary trading desks. Basel capital regulations such as the incremental risk charge have reduced banks' ability to warehouse bond positions, meaning they often have to offload clients' trades in the interdealer market right away at a loss.
The Volcker Rule, which restricts banks from taking large positions in individual securities, will only compound the situation, not least because the current rules only exempt US Treasuries - much to the chagrin of European sovereigns.
"I think it will eventually force a change in the structure of government bond markets. As banks lose the capacity to warehouse risk and buffer flows, volatility in government bond spreads will increase," said El Hayek at HSBC.
UBS reduced its footprint in October, withdrawing from SSA new issues because of the eye-watering costs of doing long-term swaps with sub-sovereign clients and in an attempt to refocus on its main wealth management client base. In contrast, RBC seems happy to continue in this part of the business, which it sees as a core franchise.
The Canadian bank's pragmatism appears to have struck home with other firms which, like RBC, languish at the bottom of sovereign league tables - never committing quite enough capital to win fee-paying syndications, or with the specialism to benefit from ancillary business.
"Frankly, there may be some clients that will see it as downside if we don't trade swaps in conjunction with cash, but it allows us to play to our strengths of extending capital in the form of counterparty risk to our core clients when they want hedges to accompany bond issuance," said one head of syndicate at a European bank currently active in several primary dealerships on the continent, including Germany and France.
"Firms like us who are in it, but do not make as much as we should with the capital we allocate, are always contemplating withdrawing."
RBC's move has drawn criticism some houses on the Street. Rivals are trying to draw business away from the bank by arguing that sovereign dealerships are the core of any SSA franchise and that RBC's withdrawal shows it is not fully committed to the sector.
Ultimately, it is the issuers that have the final say, however, and they are unlikely to want to lose such an amenable counterpart - especially in terms of the balance sheet and plentiful swap lines it offers.
The European SSA market is dominated by three borrowers, with the European Investment Bank, Europe's bailout fund the EFSF and German development bank KfW accounting for more than 85% of issuance volume this year.
The EFSF keeps a close eye on government league tables when awarding its own mandates. RBC has never won an EFSF deal, and now probably never will.
The EIB and KfW, on the other hand, are a different story. Banks constantly bemoan the asymmetric swap agreements these issuers have, and many warn that their exposure to these clients is reaching saturation point.
RBC, in contrast, said there were signs or progress in this area and reaffirmed its commitment to it by hiring a new euro swaps trader and SSA trader, who joined just days after it had fired five government traders. A week later, the bank won a lead manager mandate for a EUR900m tap of the EIB's 2.75% September 2025.
"For our core clients, we do have capacity to extend capital in the form of counterparty risk or balance sheet in trading," said Hunter at RBC. "Frankly, there may be some clients that will see it as downside if we don't trade swaps in conjunction with cash, but it allows us to play to our strengths of extending capital in the form of counterparty risk to our core clients when they want hedges to accompany bond issuance."