Regulation of liquidity in over-the-counter markets in fixed income, commodities and currencies is having a profound impact on funding costs.
Professor Darrell Duffie explained to delegates at the Fiduciary Investors Symposium at Stanford University how OTC markets are dominated by a small number of dealers affiliated with large banks. These banks, which connect with investors via their buy-and-sell orders and connect with one another in laying off those positions, charge much more today than before the financial crisis.
The market is relatively opaque for many buy-side firms. Because the current market structure is dominated by large banks, when investors call dealers to buy or sell a position, dealers are in a “better position” and “better informed,” said Duffie the Dean Witter Distinguished Professor of Finance at Stanford Graduate School of Business. Moreover, there is little opportunity to trade directly with another buy-side investor, meaning all the market share and bid-ask spread goes to the dealers.
The structure of the current market has been shaped by regulation that has been introduced since the financial crisis. Rules around bank capital adequacy make it more expensive to trade because access to banks’ balance sheets has become more expensive.
“Dealers have to have more capital to back your positions,” he said, adding that although capital regulations are a good idea, they now dictate the cost of trading.
No longer too big to fail
Other factors have also increased the cost of accessing balance sheet space. Failure resolution rules in the US and Europe, which cover liability if a major bank fails, now force the creditors of large banks, rather than governments and taxpayers, to take those losses.
“Banks have to resolve losses with creditors, there will be no bailouts by governments,” Duffie said.
It means creditors need a higher credit spread to compensate them for potential loses. So, while the probability of a default has gone down due to capital adequacy, the potential losses for the largest banks’ unsecured creditors have gone up, and with them the net cost of debt funding. It means banks are not opening their balance sheets to arbitrage trades, Duffie said.
Before the financial crisis, the credit spreads for the largest US and European bank dealers were “razor thin”. It was indicative of the fact banks were happy to fund arbitrage trades with only a few basis points of profit, safe in the knowledge they could go to the debt markets and secure cheap funding because creditors didn’t believe banks would ever be allowed to fail.
Now, it’s more expensive for banks to use debt funding to take positions, Duffie continued.
“Investors are paying for it every time they make a trade with a large bank,” he said.
Indeed, a bank will conduct a trade only if the gross profit is larger than the funding cost, Duffie said. Even a strictly positive profit-and-loss position can be viewed by the banks’ shareholders as a negative-return trade. It has led to the introduction of funding value adjustment, costs which traders must now meet to justify making a trade.
Duffie pointed out that banks’ credit ratings have lowered in reflection of the fact they are no longer “too big to fail”. It’s the removal of so-called “sovereign uplift”.
“There is no more sovereign uplift with the largest banks,” he said. “Banks are safer, but creditors are at greater risk because they won’t get bailed out if they are holding unsecured unprotected debt.”
Duffie suggested a couple of solutions to the higher cost of funding. If banks competed for trades, investors would get a better deal.
“It will mean the banks with the higher funding costs will be driven out of the market, and you will get lower costs,” he told delegates. Alternatively, trading platforms where dealers could respond to requests for quotes, could introduce competition. However, he noted there was fragmentation in the trading platform market, with few dealers answering requests for quotes and an absence of competition.