The primary dealership model has been put under scrutiny countless times over the years, with banks complaining of the steep costs and pressures that they are exposed to by acting as primary dealers.
Primary dealers are financial institutions that have been approved to trade bonds with a sovereign and they are often the only entities who can bid for new issuance of government bonds via auction, which they then resell to investors. In return, banks are rewarded (in most cases) with fee-paying syndications or bonds that are sold publicly in the international debt capital markets.
But due to increasingly fierce competition among dealers to climb up the league tables and compete for these syndication mandates, banks often end up paying more for bonds at auction than they would like, diminishing their returns. On top of this, banks need plenty of other resources, such as personnel and infrastructure, to maintain multiple primary dealerships.
Prominent exits
NatWest Markets is the most recent high-profile bank to have announced an overhaul of its government bond business. As part of what it calls a drive to a more sustainable income, the bank slashed its number of primary dealerships in Europe from 11 to six in October, resigning from its roles with Austria, Finland, Portugal, Spain and Sweden. The bank remains a dealer with Belgium, France, Germany, Ireland, Italy and the Netherlands.
“It’s become increasingly more competitive since sovereign borrowing programmes increased due to Covid-19,” says Kerr Finlayson, head of the frequent borrowers group syndicate at NatWest Markets. “But what has triggered banks to leave primary dealerships is the expensive cost to run the infrastructure. So our view was to pick our battles and use the finite resources of the bank to sharpen our European government bond offering and deliver value to customers in areas where we had the scale to compete.”
ING is another bank that has been scaling back its primary dealerships in Europe to cut costs and boost profits. The Dutch bank ended its roles with Germany and the Netherlands in 2021 after exiting dealerships with Italy, Belgium and Turkey in 2020.
But NatWest and ING are not alone. According to the Association for Financial Markets in Europe’s March 2021 government bond data report, 15 European sovereigns now have their lowest number of primary dealerships on record.
“The departures have been driven by the costs,” says a head of public sector debt capital markets at a European investment bank, who wishes to remain anonymous. “To remain in this business you have to have a proper strategic commitment for many years and not just the next 12 months, because the costs are significant. There are a lot of bonds out there and for some of them there are very tight bid/offer levels; therefore, you’re not always making a trading profit.”
Other high-profile departures over the past few years include Credit Suisse, which relinquished its European primary dealerships altogether and exited trading of European government bonds in October 2015. Meanwhile, Swiss rival UBS, has been aggressively cutting its dealerships since shutting down its sovereign, supranational and agency bond business in 2012.
Squeezing out smaller banks
One of the frequently cited criticisms of the primary dealership model is that smaller banks are being squeezed out due to their inability to compete with the bigger banks, which are in turn claiming an even bigger market share.
“It’s a very competitive model in a market with razor-thin margins, where big IT investments are needed and where scale of coverage is creating a big advantage for the top market makers — much more than before, as the European government bond market has globalised a lot over the past decade,” says Bernard Delcour, head of rates trading, Europe at ING.
“The standard primary dealership model is pushing primary dealers to become even more aggressive to climb in the rankings, in order to increase their chances for a mandate or some cross-sell with certain customers,” says Mr Delcour. “This model makes it a profitable business for the top players with a global coverage of customers, but it makes it extremely difficult for the tier-two players.”
So how can the primary dealership model become more attractive to smaller banks?
“Our short answer would be to give equal treatment to all banks — and in particular to do less syndications,” says Tammo Diemer, member of the executive board of the Finanzagentur, Germany’s finance agency for borrowing and debt management. “Larger banks clearly benefit more from syndications than smaller banks. As an issuer, we rely on larger banks for syndicated transactions. With auctions that is different.
“This is one reason why we rarely do syndicated transactions. The last two years have been exceptions due to increased financing needs [due] to the coronavirus pandemic. From 2016 to 2019, we had not done any syndications at all. In syndicated transactions, we have to select a small number of banks that then have preferential access to that bond. This is in contrast to our liberal approach for auctions.”
However, syndications are a big incentive for banks entering primary dealerships in the first place, due to the fees that come with them. Years ago, the big attraction for banks being involved with primary dealerships was the branding element of being involved in helping finance government debt. After all, financing government debt was one of the main reasons why banks were created. But now, as costs have risen, it is increasingly about the bottom line and making a return.
Some argue that having a smaller pool of primary dealers would be better in terms of reduced competition, but it is not that simple.
“Too few banks could pose challenges in distributing our debt among a wide enough range of investors, or difficulties in the price-discovery process in our market,” says Pablo de Ramón-Laca, Spain’s director-general of the treasury and financial policy, and chair of the Economic and Financial Committee’s Subcommittee on EU Sovereign Debt Markets. “On the other hand, too many banks playing an active role as primary dealers could also pose problems, in terms of management for the treasury, or making it difficult for large investors to find a large enough bank as a counterparty.
“Primary dealership models are carefully calibrated designs, with delicate and interdependent incentive structures. This makes creating an efficient primary dealership system a complicated affair, which must be under constant supervision. Additionally, as markets change, sovereigns’ needs from their primary dealers may also change, requiring modifications to the primary dealership model. This constant need to change and update ... adds even more difficulty to the process of optimising a primary dealership model’s structure.”
Technology to the rescue?
The fixed income market is known for lagging behind other areas of banking in terms of the use of technology and innovation. But that is slowly changing with the increasing use of fintech, blockchain and digital platforms. The use of technology is also a key way of helping banks mitigate the costs of maintaining primary dealerships.
“Every bank strives to manage costs and increase their income,” says Cyril Rousseau, chief executive of Agence France Trésor, France’s sovereign debt office. “Indeed we are beginning to see technological changes going on and this can be a way for banks to improve their business models.”
Mr de Ramón-Laca agrees that there are “clear signs of innovation in primary dealerships”.
“Banks are introducing new technologies, such as using algorithms for high-frequency trading,” he says. “This uptake of new technologies by banks can be helpful if it improves their efficiency over time.”
“The fixed income market will continue to evolve, and the primary and secondary markets will adapt to these developments,” says Mr Diemer. “There has been a lot of innovation in the equity market over the past few decades, but that is less the case in the bond market, where we still have T+2 settlement for example. But there is blockchain technology on the horizon, which offers potential for change in both the back and front office.”
The Finanzagentur has first-hand experience of how blockchain technology can be used to help improve the efficiency in the settlement of bond transactions. In March 2021, together with Deutsche Börse and the Bundesbank, the Finanzagentur developed and tested a settlement interface for electronic securities with the use of distributed ledger technology to issue a 10-year bond. The experiment showed that it was possible to settle securities in central bank money far quicker and without the need of a central bank digital currency.
“We expect to see an increased use of technology in the fixed income markets to support primary dealer’s various requirements and the efficient servicing of their clients,” says Mr Finlayson.
EU’s arrival
The arrival of the EU as a super-sized issuer in the bond markets with a primary dealership model for its €800bn Next Generation EU (NGEU) programme has added competition for the attention of banks.
Given the high-profile status of the EU, and the amount it will issue over the next few years, banks have been keen to participate in the issuer’s transactions. But this has affected demand for other sovereigns, according to analysts, who attribute the lack of demand for several of Germany’s auctions towards the end of last year to the introduction of the EU’s auction programme. The argument is that banks can achieve more by bidding on the EU’s auctions than they can on Germany’s, given the EU will be doing far more syndications.
However, strong communication between the EU and other sovereigns means this has not been a major issue as of yet for sovereign issuers.
“We were initially concerned of the risk of bad coordination between current issuers and the EU, but that risk has not materialised,” says Mr Rousseau. “Instead, what we have seen is the EU approaching the market with transparency, which allows everyone else to smoothly coordinate their own issuance.”
Mr de Ramón-Laca argues that the EU’s arrival has benefited other European sovereign issuers.
While the EU’s arrival has certainly added a new and very large player to the European issuer scene, we have not seen detrimental effects on European sovereign issuers
“While the EU’s arrival has certainly added a new and very large player to the European issuer scene, we have not seen detrimental effects on European sovereign issuers,” he says. “Quite the contrary — the EU’s arrival has brought renewed interest in European primary dealerships.
“One key element of this success has been the transparency and predictability shown by the [European] Commission (EC). By announcing their issuance windows for auctions and syndications, other European [debt management offices] can plan their own issuance around these times. Additionally, it allows market participants to adjust their balance sheets in time, helping to avoid competing-supply issues.”
Mr de Ramón-Laca adds that there has also been a “crowding-in effect” from the EU’s issuance, attracting more investors to euro-denominated financial assets.
“This is because the EC’s issuance increases the supply of euro-denominated safe assets in the market — a role previously played only by core sovereign debt, which was in short supply,” he says. “With the sharp rise in issuance due to the pandemic, a new euro safe asset, such as the one provided by NGEU, is a much-needed element for euro financial markets.”
So what does the future hold for Europe’s primary dealership model?
“It looks like the model is to stay around for quite a bit longer, even if this might be with less primary dealers on average in the future,” says ING’s Mr Delcour. “For the biggest banks, it’s still an overall profitable business, while the issuers get a good service in return, in terms of daily liquidity and good bidding in auctions. We expect banks with smaller market share to drop off, unless they are being compensated by their governments with cross-sell business.
“The larger banks will become larger and hence, for them, this model works. This, however, creates a potential issue for the issuers since the dependency on these bulge-bracket firms will become larger.”
“Something similar to the primary dealership model will always be necessary,” says Mr de Ramón-Laca. “Even if some of the services currently provided by primary dealers lose their relevance, there will always be a need for other services which are intrinsically linked to sovereign issuance.
“Regarding possible alternatives, the ‘buffer’ role and the other services carried out by primary dealers don’t necessarily have to be played by banks,” he adds. “In theory, they could be played by other financial entities. However, banks are likely the best candidates, due to the large size of their balance sheets, their expertise and the strong regulatory regime. This makes them capable of absorbing large amounts of issuance safely and fully respectful of financial stability concerns.”
