News Analysis

Call for clarity

Monday 16 May 2016 17:18 London/ 12.18 New York/ 01.18 (+ 1 day) Tokyo

Valuation uncertainty adds to liquidity debate

Banks' diminished market-making capacities and shrinking inventories are taking their toll on liquidity, particularly in the ABS and structured credit markets. However, a lack of clarity over valuations may also have a role to play in the liquidity debate.

"Ultimately what the industry has to figure out - both for the good of the buy- and sell-side - is to improve pricing transparency in order to create liquidity," says Ron D'Vari, ceo and co-founder of NewOak Capital. "Sellers need to know where assets can be sold and buyers need to be confident on the price. Lack of confidence on the price is making the market much less liquid and hence more volatile."

He adds: "Today, there's not a single asset manager that will tell you they don't have a liquidity issue. Investors need to know they are getting the right price. Are we getting real executed prices or an indication? That is a very big confusion in the marketplace right now."

To add to the confusion, illiquid bonds can, in some instances, appear more liquid than they actually are. One European valuation control director explains that when an asset becomes illiquid, it is not unusual for a bank valuation professional to mark their book so that the asset in question gets into the consensus.

"If they don't, they will end up with big IPV charges," he says. "The end result is the bizarre case where something that is not liquid is looking deceptively liquid because everyone is trying to get into the consensus. There's a danger of understating the valuation uncertainty on illiquid assets if you're using consensus data alone."

D'Vari also expresses his concerns over the control that the pricing vendors try to exert on firms using their data. "Valuation specialists typically consider published pricing data if they have access, but not in its exact form," he says. "However, pricing data vendors may consider this as re-distribution and be unwilling for valuation agents to use the data in such a way."

Illiquidity and the absence of pricing transparency in the ABS market is currently most keenly felt at the bottom of the capital structure. According to Andrew Dennis, portfolio manager and ABS specialist at Aberdeen Asset Management, one of the challenges associated with pricing ABS is the huge number of ISINs, some of which are very small in terms of size.

"As you go down the capital structure, certain tranches can be very small and might only be held by one, two or three investors," he says. "They are inherently illiquid. Further up the capital structure, tranches are bigger, more broadly held and trade more actively."

He adds: "Our investments tend to be skewed towards the top end of the capital structure. The liquidity isn't brilliant there, but not hugely worse than things we see in other parts of the credit market. Pricing points are reasonable and it's relatively easy to triangulate into what a reasonable price might be."

Structured finance has added layers of complexities for pricing that are not applicable in broader fixed income. For example, working out a return over Libor for an RMBS does not give the full picture in terms of pricing.

"You've got to work out what the average life of the bond is going to be - which is driven by prepayments and whether a bond is called or not - as well as other inputs and assumptions," says Dennis. "One investor's assumptions will be different to another investor's assumptions. You might end up with a bond that looks like it has three different prices, but actually people are buying it with return expectations that are similar - they just have different expectations on what the cashflows on the bond might be."

Liquidity issues are not specific to the ABS market, but they are felt more keenly, given the impact on banks required capital for trading. Indeed, many banks have been redirecting their strategies and cutting back on ABS operations as these functions become less profitable or less viable under new regulations.

The most recent example is Credit Suisse, which shut its European ABS operations at the end of March. Other banks are, meanwhile, trimming down their market-making capacity, and those that are still open for business have much smaller inventories.

"Banks always tend to over-react," says a European structured credit investor. "You tend to see banks dropping a whole department, rather than just a pro-rata scaling-back of what desks will carry and what risks they are prepared to take."

He adds: "It is this sort of knee-jerk reaction that adds to the liquidity problems. It is also one fewer pricing source, reducing valuation transparency further."

While the sell-side restructures and re-directs operations, the buy-side is also evolving in order to take on roles that were once dominated by sell-side institutions. For example, there have recently been large portfolio sales of mortgages and NPLs within the ABS market where the buy-side was the primary mover, rather than banks.

ICMA has, meanwhile, suggested in a recent report that hedge funds may have a role to play in terms of liquidity. While the association says that traditional buy-siders will most likely not step in as 'price makers' on central limit order books (CLOBs) or other agency-only trading venues, hedge funds may step in (providing it suits their trading strategies) and provide larger illiquid pricing, bolstering liquidity. This is because hedge funds do not have the same legal structure and mandates that asset managers do.

"The buy-side is already more involved with liquidity initiatives, but I don't think that market-making is something that can transfer to hedge funds," says the structured credit investor. "You don't make 15% returns from market-making - it's a different game."

16/05/2016 17:18:06