An interesting facet of market structure is how flexible markets can be, twisting and turning to conform with the nature of the product, the legal and regulatory environment in which they operate and the scope of the buyers and sellers they’re designed to meet. Market structure, itself honed through market competition, is endlessly responsive to changes in rules, technology and the markets for the underlying instruments themselves. Thus, to truly understand market structure, it’s necessary first to understand the markets they mean to facilitate.
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An interesting facet of market structure is how flexible markets can be, twisting and turning to conform with the nature of the product, the legal and regulatory environment in which they operate and the scope of the buyers and sellers they’re designed to meet. Market structure, itself honed through market competition, is endlessly responsive to changes in rules, technology and the markets for the underlying instruments themselves. Thus, to truly understand market structure, it’s necessary first to understand the markets they mean to facilitate. These can vary significantly across asset classes and regions, and looking at one aspect of a market with assumptions built in another can lead to fundamental misunderstandings. So it is with the fixed-income markets in Europe and the United States.
Government Bonds: E Pluribus Magis (from many, still more)
The only real similarity between American and European fixed-income markets is their size—a closer look reveals stark differences. In the United States, cash U.S. Treasuries trade $500 billion a day. There are $15.7 trillion of U.S. Treasuries outstanding in public hands, so this volume represents a daily turnover ratio of 3.3%. U.S. Treasury securities are all claims on the federal government, rated AAA by both Moody’s and Fitch, and can be used as a proxy for the risk-free rate.
In Europe, by contrast, there is no central fiscal authority. The only pan-European sovereign credits are the European Stability Mechanism (ESM) and the European Financial Stability Facility (EFSF), special-purpose entities set up to pool the resources of the Eurozone during the crisis. They have issued just over a quarter of a trillion dollars of debt. Given their novelty, however, they’re rarely traded and they don’t regularly issue new securities.
Instead, the sovereign debt markets in Europe are organized around the member states. In aggregate, they have similarly high levels of debt: €9.5 trillion (including the U.K.) or $10.8 trillion in U.S. dollar terms. This is the same order of magnitude as the $15 trillion U.S. Treasury market and slightly larger than the $9.1 trillion U.S. corporate bond market. However, it is highly fragmented among the member states. The largest issuer has just under €2 trillion outstanding, and only four countries have more than a trillion.
The wide variety of credit quality among European government bonds compounds this fragmentation. Among the top five issuers, only Germany is AAA rated, while the largest issuer, Italy, is BBB rated. The next two largest, France and the U.K., are rated AA. The smaller issuers vary even more widely, from Denmark and the Netherlands at AAA, to Greece at B+. An additional complexity is that even the AAA sovereign bonds denominated in euros face a risk that U.S. Treasuries do not: the possibility that the euro ceases to exist, creating “redenomination risk.”
Closer to Munis than Treasuries
The European government bond market bears little resemblance to the U.S. Treasury market. It is closer in scope and structure to the U.S. municipal bond market. Indeed, if California were a European country, it would be the sixth largest issuer behind Spain. Similar to the mystery surrounding redenomination risk for euro-denominated sovereigns, there is a parallel ambiguity for U.S. states, as no explicit bankruptcy code would apply to them in the event of a default.
Additionally, both U.S. states and most European governments operate under relatively strong fiscal and monetary constraints. U.S. states do not control monetary policy, nor does any individual Eurozone state. While the U.S. government “debt limit” is a political frivolity when it is not a fiscal formality, many U.S. states have legally binding debt limits that actually do constrain their capacity to issue new debt to fund spending.
The European Stability and Growth Pact (SGP) is more robust than the U.S. debt ceiling. It limits the debt-to-GDP ratio as well as the size of fiscal deficits. These limits have proven difficult to enforce and were unable to forestall the sovereign crisis of 2010–2012. As a result, the SGP was revised in 2011 and enforcement made more stringent.
In practical terms, the revised SGP puts many European sovereigns in a similar position to that of U.S. states: being partially, and thus not predictably, constrained in their borrowing. These constraints and the smaller amounts outstanding mean that the total outstanding, as well as the average term of the debts of individual countries, can change substantially and quickly, relative to the U.S. Treasury market. Thus, financial activities that require an underlying bond market to have consistent issuance and maturity are more difficult to perform with European government bonds.
This is a major issue. European government bond markets look like the U.S. state bond markets, yet they’re called upon to perform the functions that are performed by the U.S. Treasury market. Take, for example, the establishment of a yield curve and the creation of instruments with which to hedge against changes to it. The ideal instrument for this task has a large, regular issuance all along the curve, ensuring regular transactions at scale at each point. Imagine trying to establish and hedge the dollar yield curve using only California municipal bonds. This is the position in which Europe finds itself. In addition, these markets are how the European Central Bank (ECB) has had to implement its quantitative easing program. The relatively small size and variety of credit issues forced them to add corporate bonds.
Smaller Bond Markets Yield Larger Futures Markets
With all this work to do in the European economy, however, the European sovereign markets have much lower trading volumes than those in the United States. Naturally, the absolute level is significantly lower, given the fact that there is only two-thirds as much outstanding. But the turnover ratio—the proportion of the total outstanding that trades every day—is also much lower. In Germany, the turnover ratio is just over 1.5%, half that of the United States. Other European sovereigns are even lower than that. Spain is an outlier, trading nearly as much volume as Germany but with a turnover ratio of 2.5%, still significantly lower than the U.S.
Another difference between Europe and the U.S. is the supporting role of the futures markets. U.S. Treasury futures trade slightly less per day on a notional basis than the cash market. In European government bond markets that have associated futures markets, the futures trade more volume—in some cases, significantly more. The French government futures traded on Eurex trade about 1.5 times more than the cash. Italian government bond futures trade about twice as much, and Bund futures across all tenors trade a whopping seven times the ADV of the underling cash bonds. What’s more, the open interest of all Bund-related futures, €546 billion, is about 50% of the outstanding notional of the underlying bonds themselves. By comparison, U.S. Treasury futures’ open interest is less than 10% of the debt held by the public.
It seems that in Europe, government bond futures markets perform some functions that cash U.S. Treasuries do in America. In addition, the Bund future may be doing the work of the Eurodollar future. Eurodollar futures are a major source of interest-rate hedging in the U.S.—so much so that they have an open interest of $14 trillion, roughly the same size as the outstanding issuance of U.S. Treasuries. This product has no equivalent in Europe. It may be that firms are using Bund futures as alternatives to German government bonds, as a proxy for European government bonds generally, and also as a substitute interest-rate hedge, since the Bund drives the yield curve in Europe.
Corporate Bonds: Slowly Supplanting Loans
Just as a look beneath the surface of the European government bond market reveals significantly different market dynamics than in the U.S., so it is for the corporate bond market. European corporate bond markets are smaller, both in absolute terms and relative to GDP, than those in America. This is because of historic economic atomization along national lines that the European integration project is trying to overcome. While Europe has produced many global champions—it has as many members of the Fortune 500 global companies as the U.S.—the middle-tier European corporations are significantly smaller. This is because many midsize to smaller European companies were originally organized nationally, and access to a pancontinental market, which enables them to capture scale economies, is a relatively new phenomenon in the context of European history.
There are significant scale economies in bond issuance. Underwriting fees for bonds are high relative to the costs of bank borrowing, so the size of the issuance has to be at a scale that justifies the higher fees. The stable capital base and a wider investor pool that make bond issuance attractive can easily be large enough to offset the higher costs for larger firms, but much less so for midsize firms. A larger proportion of European corporations, therefore, do not possess this scale relative to those in the U.S. Thus, in Europe, corporate bonds are a much smaller proportion of the aggregate capital structure.
The ratio of financial to non-financial issuers is also markedly different. In the U.S., 70% of bond issuance is by non- financial corporates (NCFs), and 30% is done by banks. In Europe, these numbers are reversed, with banks doing 70% of issuance. In other words, 70% of the corporate bond market is comprised of bonds issued by banks for the purpose of funding the corporate loan market, because banks have the scale that many European corporates lack.
While this is true as it stands, it should be noted that there have been significant shifts in the wake of the financial crisis. European NFCs have nearly doubled their bond issuance since 2008, while their U.S. counterparts have increased theirs by more than 150% over the same period. At the same time, they have reduced their reliance on loans. This is both a matter of policy and of pragmatism. Banks rationing their balance sheets in the wake of the financial crisis and the implementation of Basel III have very likely caused a significant shift in the relative economics of bond issuance vs. loan issuance. This is also something the EU itself would like to see because it reduces the centrality of the banking system to the economy at large, reducing systemic risk. It has been working to encourage the development European bond markets, as have the governments of India and China in recent years.
Too Big to Fail, Too Big to Save
Something often overlooked in European capital markets is the massive scale of the banking system relative to the size of European national governments. One of the triumphs of the European integration project has been the creation of a single continent-wide market for banking services. As a result, European banks have developed continent-wide, and some, even global businesses. However, there is no continent-wide fiscal authority, and so, the European banking system operates on a scale out of all proportion to the individual European states.
Take France, for instance. In 2016, the top five banks in France had combined assets of €7 trillion. French GDP that year was €2.2 trillion, meaning that the French banking system had assets that were 300% of GDP. In Spain, it’s 250%, in Italy, 135% and in relatively conservative Germany, 115%. In the U.S., that ratio is 48%. This was why the U.S. was able to rescue the U.S. banking system in 2008. The TARP bailout was a 5% of GDP capital injection into the banking system. At the time, the debt-to-GDP ratio was 60%, and since the U.S. can issue its own currency, there was no doubt that the U.S. could finance it.
A similar rescue scaled to the size of the French banking system would require France to borrow 30% of GDP, at once. There is no chance of that, so the European banking system is both too big to fail and too big to save. This was the imperative behind the rescue of AIG, which had insured the balance sheets of the European banking system via CDS far beyond its capacity to pay out claims. Seen in this light, the aggressive deleveraging sparked by Basel III, a source of significant consternation to bankers, was a moral imperative for finance ministers.
Non-financial corporate bond issuance is not evenly distributed across the EU member states. It is highly concentrated and is only partially related to the size of the economy. France and Britain have over half of all the outstanding corporate bonds between them. Germany, the largest economy in Europe, ranks fourth. The Netherlands has more than twice as much as Italy and Spain combined, despite having an economy half the size of either. There are many reasons for this, but it should be noted that there is no uniform insolvency code, nor is there a uniform tax code across the EU. This very likely has a strong influence on issuance decisions. The importance of jurisdictional issues is highlighted by the fact that Luxembourg, one of the smallest EU economies but with capital-friendly laws, is the sixth largest issuer.
Central Banks are Key Bond Holders
It’s also instructive to look at differences in the investor base that holds European corporate bonds. Interestingly, the share of bonds held by foreign investors in both the U.S. and European markets is identical: 29%. The major difference between the two is that fully a third of European corporate bonds are held by the euro area monetary authorities. Keep in mind that the CSPP, the ECB’s extension of quantitative easing into the corporate bond sector, represents only €175 billion, or about 1% of the total outstanding. The other 32% of the corporate bond market is simply held by the national central banks. Of this, only €100 billion is held by NFCs, the rest by banks. Thus the largest issuer-holder relationship in the Eurozone, €2.5 trillion, is the direct financing of European financial institutions by their central banks. As we have seen, these banks are the source of the loans to midsize corporates.
Put another way, only 38% of the European corporate bond market is held by domestic investors in the EU, as opposed to 70% in the U.S. Among the domestic investors, the largest holders in both markets are insurance companies and mutual funds. Interestingly, in both markets, banks—the market intermediaries—hold roughly 4% of the outstanding notional. The one major difference is the scale of ETF holdings in the U.S. vs. Europe. In the U.S., ETFs hold 3% of all outstanding corporate bonds. In Europe, ETFs and passive investing in the bond markets have not had the same influence on investors as they have in the U.S. Indeed, despite recent growth, ETFs account not only for less than 1% of the bond market, they count for less than 1% of the fund market.
What Does It Mean for Market Structure
The main themes of market structure in the wake of the crisis have been the rise and consolidation of market infrastructures, the reduction in the use of bank balance sheets to intermediate markets, the leveraging of market infrastructure, and the technologically facilitated capital efficiency by non-dealers to compete with, or replace, dealers. All of this is most clearly seen in the general and universal forward march of electronic trading across every asset class and geography. The only difference among asset classes generally has been the rate of e-trading growth. That said, there are very important regional differences in market structure, and it is important to take those into account.
In Europe, e-trading has been growing, but it’s important to see that growth through the lens of what makes Europe unique. The Greenwich Associates 2018 European Fixed-Income Investors Study found that slightly more firms were trading government bonds electronically, but the volumes of e-traded government bonds declined slightly, from 52% to 48%. To put this in context, in Germany, the benchmark for government bonds in Europe, the vast majority of trading takes place in the futures market, not the cash market. Structural factors surrounding the nature of the sovereign debt markets in Europe have created a vastly greater reliance on futures, which are 100% electronic.
The same is true in the corporate bond market. The past few years in the U.S. has seen the emergence of the first true all-to-all platform, MarketAxess’ OpenTrading™. This is a substantial innovation, and its growth has been robust. Much of its liquidity has been provided by firms that are conducting the create-redeem arbitrage for fixed-income ETFs. The techniques developed in the course of this business have been key to the emergence of what may be the next important shift in corporate bond market structure: the move to list trading.
In Europe, where the bond markets are significantly more fragmented and where ETFs have yet to gain a comparable level of traction, many of these innovations may also struggle to achieve the success that they have in the U.S. Indeed, it’s likely that Europe will spawn many of its own innovations which will likely be created hand-in-hand with the governments and central banks who, as we have seen, have more than an academic interest in corporate bond markets.
In the United States, the regulatory wave has largely crested, and the American financial system this year commemorated the 10-year anniversary of the Lehman bankruptcy, which Americans consider to be the nadir of the financial crisis. In Europe, the crisis rolled on into 2012, once it metastasized into a sovereign crisis in the periphery of the Eurozone. As a result, the regulatory wave in Europe has yet to crest. This is due to the financial crisis playing out differently in Europe, but also because the project of integrating the European economy has not been completed, and improving the quality of the bond market is something regulators are thinking deeply about. So are all the firms who have an interest in market structure, from the dealers to the platforms to the issuers. Watch this space.