FIESTAS DE LA MERCED

Dealer banks are important actors in financial markets. They provide liquidity for financial instruments by charging a spread and ensuring a continuous (or quasi) trading activity

Dealing activities

instrument very quickly, with limited price impact and at low cost. They are involved in key capital markets activities to support this liquidity, including:

 Securities borrowing/lending.

 Securities purchase/sale (at discount, i.e. repo).

 Securities trading.

All these activities may or may not appear on the balance sheet, depending on the tools and types of resources committed by the dealer. Securities trading can be split in proprietary trading (trading on behalf of the bank with own capital), principal trading (trading securities or over-the-counter derivatives to earn a spread),41 _{and agency trading}

(trading on behalf of a client without interposing itself in the transaction). These are the core activities of a dealer bank, which typically stands between a buyer and a seller of financial instruments. It can operate by putting at risk own capital or with matched books using principle transactions. Dealer banks can be also part of important banking groups that provide other services, like commercial banking, asset management and investment banking (such as underwriting, etc.). In effect, the dealer banking business requires significant capital and cash, which can be easier to find when putting together different banking activities.

This section analyses the current status of the dealing industry in Europe (including Switzerland) and the US via a dataset collected from the top 26 dealer banks,42 _which

account for the vast majority of dealer banking activities in the two regions. Due to the high cost of running such a business, the industry is fairly concentrated.

The US (plus one non-US) dealer banks are: J.P. Morgan, Goldman Sachs, Citigroup, Morgan Stanley, Bank of America Merrill Lynch (BoA ML), Jefferies, Nomura (Japan). The European (and Swiss) dealer banks are: Barclays, Credit Suisse, BNP Paribas, Société Générale, HSBC, UBS, Crédit Agricole, Deutsche Bank, Natixis, ING, Santander, Bank of Nova Scotia, Unicredit, Commerzbank, Royal Bank of Scotland (RBS), ABN AMRO, Unicredit, BBVA, Banca IMI.

Top 26 dealers

The financial crisis originally hit dealer banks in several ways. Among others, the drop in trading volumes, the tightening of capital requirements, especially for those holding large securities inventories, and an environment with very low long-term interest rates and stricter capital requirements have increased the capital costs of inventories (balance sheet space) and pushed some banks to cease well-established trading activities or even restructure the entire business model towards more hybrid models, e.g. a combination of securities dealing, trading and asset management services. Combined with accommodative monetary policies, which allow banks to access cheap liquidity, it did not necessarily result in lower costs of trading activities in markets with significant dealer presence, but spreads widened and market-makers are willing to provide liquidity for shorter time periods (PWC, 2015). More volatile pricing may ultimately become an

Post-crisis financials

41 _{This can also come in more complex market-making agreements in continuous trading environments, where} the dealer banks provide liquidity to the market (a bid and ask) in exchange for a spread.

42 _{Dealer banks were selected in part from the AFME list of primary dealers and, for non-European banks, from} other sources. From the data collected and matched with aggregate market numbers, the coverage of dealer banking activities shall be very close to 90% of the market.

embedded feature of the new financial market structure. Nonetheless, the US corporate bond market has in recent years moved towards a more agent-based model with limited impact on liquidity (Adrian et al., 2015).

In line with this background, while total revenues are stable and assets have even increased (from €22 trillion to €26 trillion), trading-related revenues and assets have dramatically gone down compared to pre-crisis levels (see Figure 36).

Trading activities

Figure 36. Revenues (lhs) and trading assets/liabilities (rhs; €bn; 2006 vs 2014)

Source: Annual reports. Eurostat (exchange rates).

This is particularly the case for European banks, which have seen a drop in trading assets as many of them ceased or scaled down capital intensive activities (see Figure 37), such as fixed income, due either to a restructuring forced by losses (as in the case of RBS) or to a voluntary restructuring towards a lighter capital structure and business model (UBS and Credit Suisse).

Figure 37. Trading assets by dealer (€bn, 2006 vs 2014)

collateralisation of an OTC derivative transaction, or for a third-party transaction such as repurchase agreements or securities lending/borrowing. The collateral dealing activity continued to drop in 2014, compared to recent years, which is consistent with the reduced involvement of banks in wholesale financial markets activities (see Figure 38). The reuse rate of collateral of selected banks has also gone down since 2006, but the drop has been partially recovered as banks improve their financial health and can redistribute more collateral to the system.

Figure 38. Total collateral received and repledged (€bn, 2010 vs 2014)

Note: No data for Banca IMI.

Source: Annual Reports. Eurostat for exchange rates.

Figure 39. Reuse ratios, selected banks (collateral received over collateral sold/repledged; %)

Source: Annual reports. Eurostat for exchange rates.

Moreover, Figure 40 suggests that the drop is consistent across all dealer banks in the sample, as their market activity in this business shrinks.

Figure 40. Collateral received and repledged by dealer bank (€bn, end of 2014)

Notes: No data for Banca IMI. For 2010 missing data for BBVA, Unicredit, Jefferies. Citigroup data are estimates.

Source: Annual reports. Eurostat (exchange rates).

Evidence on the development in the repo and reverse repo (RRP) markets is mixed. Repo and RRP are important funding tools for asset managers, both for funding (repo) and returns purposes (RRP). Banks that had large repo or RRP exposures have reduced their activities, compared to other banks in 2006 (see Figure 41). This happened in favour of greater redistribution of the business across the industry (see Table 3), with many banks that have seen a slight increase since 2006. Nonetheless, the repo market has shrunk by roughly €1 trillion since 2006 (ICMA, 2015) to its current level of €2.7 trillion (gross). For our sample, repo activities lost as well almost €1 trillion, currently at €2.1 trillion (net),43

while the reverse repo market went down by roughly €500 billion, currently at €2.09 trillion (net).44

Repo and RRP

Table 3. Repo and reverse repo, net amounts (€bn, 2006-14)

REPO RRP 2006 2014 2006 2014 Top 5 US 994 596 683 619 32% 28% 26% 30% Top 5 EU 1,248 815 1,102 738 40% 38% 43% 35%

Total repo top 25 dealers (net) 3,121 2,125 2,588 2,090

Figure 41. Repo & RRP (net amounts, €bn, 2006 vs 2014)

Source: Annual reports.

Last but not least, dealer banks are key players in the market for over-the-counter derivatives, which are important tools for risk management of firms and investment funds. The dealer bank often offers these contracts because of its possibility to stand on the other side of the transaction, with a hedged exposure via internal risk management operations. The market is highly concentrated, with the top 10 dealers controlling more than 80% of the market (see Figure 42).

OTC derivatives

Figure 42. Top dealers’ positions in OTC derivatives (notional amounts, €bn, end of 2014)

Note: No data for ING, BBVA or Unicredit.

Source: Annual reports.

The US market is more concentrated, while European banks have a bigger market share (59%). Nevertheless, OTC derivatives transactions are international in nature and so the location of the bank does not say much about market integration.

Section 3.4.3 will review the overall market for OTC derivatives at European and global levels.