Creditflux Newsletter

For the second time in three years we are learning that credit markets depend upon liquidity. Being forced to sell quality assets to the only bidder willing to show a price is a memorable experience not willingly repeated. But there is plenty of that going on right now. So why has liquidity in credit markets been so poor over recent months?

In cash markets – and in European cash markets in particular – liquidity has at times evaporated. Back in 2008 we could argue that the European credit market was immature; traders were less experienced than in the US; derivatives were new; it was our first crisis in the new era; and the market was awash with complicated structures that no one could understand. But second time around all these factors are mitigated. And yet liquidity is arguably worse.

Step forward the guilty men (and a few women). First: banking regulators the world over have been determined to increase the capital held by banks on their trading books. The economics of market making in credit products have changed. Tidy traders who go home with a flat book every night are still highly sought after by banks, but those traders whose style is to warehouse risk for a while find themselves looking for a job. To go home flat you need high turnover and an extensive distribution network or sales force. The remorseless logic is that any market can only support two or three houses like this.

Back in the day, a whole tier of market makers were content to do sub optimal amounts of flow business and lose a little money to garner information useful to their origination and proprietary trading desks. But prop trading is now frowned upon. Wolseley imagines that Adair Turner, chairman of the FSA, is pleased that the actions of his organisation have encouraged many banks to exit liquidity provision in credit markets. This, so the logic goes, will make a banking crisis less likely. So that’s all right then.

But Lord Turner and his ilk are not the only guilty men. Step forward the banking executives: you know who you are. The regulators wouldn’t have been able to dislocate the market as much as they have if banks had allowed the evolution of the credit market, from a bank market-maker model, to an open customer-to-customer model. The banks, in particular the two or three largest banks that now control large concentrated market shares, have resisted this evolution. The demise of the second tier market makers, precipitated by higher capital charges and the exit from proprietary trading, has increased the profitability of the market making desks at these few banks.

Illiquid markets, populated with customers who have no choice but to leave orders to work, is a pretty conducive environment for making money. If the Blues – Bluebay, BlueMountain, Bluecrest – and all their hedge fund friends, were able to show their prices in one place, and at the same time, credit markets would be more liquid but Megabank would make less money.

Wolseley believes that we are on a journey from a bank market-maker denominated market to some sunlit upland that looks more like an electronic version of the old trading pits in Chicago. This will be a market where dozens of market makers trade with each other, using electronic markets and central clearing to manage their counterparty credit exposure.

The danger is that, before we reach this utopian future, politicians will do something to fill the gap where credit used to be. We could end up with capital being allocated by bureaucrats. And that would be a disaster.