Creditflux Newsletter

Few investors or commentators expected the rally that has gripped the credit market from calendar new year to lunar new year. Armchair generals tell Wolseley that the rally was sparked by the injection of liquidity by the ECB in its LTRO exercise. (By the way, LTRO stands for “long term rescue operation” according to one British newspaper.)

Wolseley notes that many investors are sitting on piles of cash. On a recent swing through Swiss private banks, he heard mention of 30% cash holdings. And that is before another 10% in gold and gold stocks. It is likely that a little of this cash is being put to work in the credit market and that it has sparked a rally in a market which is much less liquid than it was.

Indeed, one powerful factor that explains the magnitude of the rally is the lack of market making, and the lack of risk capital in the credit market. This is a theme that Wolseley has addressed before but makes no apology for raising again.

Our market has traditionally been based on an inner core of banks and brokers making prices to each other and to an outer core of customers. Custom and practise dictated that you were either a market maker or a customer. “Back door accounts” (market makers disguising themselves as customers) were quickly identified and weeded out without the need for a Volcker rule.

But regulation, losses and exits have reduced the capacity of the inner core to make markets. Look at the numbers for dealers’ inventory: with the cost of capital for trading books increasing dramatically, dealers are reluctant to hold much.

The unintended consequence of this is thin liquidity. If a dealer sells a bond it needs to replace it quickly. The triumph of the credit derivative market was to increase liquidity in the credit market enormously. The triumph of regulators, aiming to promote market stability, is to so undermine liquidity as to make markets more volatile and less stable.

Similarly, the new issue market is handicapped by the increased reluctance of banks to underwrite new debt issues. In a healthier market, the recent rally would have been met with a comprehensive and diverse range of new issues, with dealers happy to warehouse and hedge some inventory against future demand. Higher capital charges, tighter risk limits and concern about liquidity gaps have sharply curtailed underwriting risk appetite, particularly in Europe.

But markets adapt. As regular readers will know, Wolseley believes we are part way through a transition from a specialist market-maker market to something more akin to an open outcry pit, with a much wider range of participants acting as principals. There is probably now more market making risk capital in the hands of hedge funds and other sophisticated so called “buy side” accounts than is allocated to market making by JP Morgan, Goldman and their like.

What the low liquidity January rally demonstrates is that we need to complete quickly the transition from one market model to the other. Few benefit from the spectacle of hundreds of customers falling over each other to participate in the January sales, whether at Macy’s or at the credit market maker that is caught short. We need some customers to get behind the tills and to start making markets.

That requires open access to exchanges and clearing houses for a larger and more diverse group of participants. It also needs central banks to grant buy side institutions the same repo rights as banks.

These are major changes, but without them credit markets will remain unstable.

Wolseley is a leading practitioner in the credit market. Feedback is welcome at wolseley@creditflux.com