European governments -- many of which are already struggling to woo buyers for sovereign debt -- could find it even harder to raise money as the investment banks they relied on to sell the debt baulk at the cost.
Banks are reconsidering the cozy relationships that in the past saw them subsidize bond sales in the hope it would curry favor with governments and lead to other lucrative business, such as state privatizations.
Any bank designated by a country as a primary dealer must commit to buying a certain percentage of government-issued bonds in return for a guaranteed chance to participate in the auction.
This was once a coveted position given the regularity of debt auctions, but scarce capital means banks are now not willing to take on the increasing risk of being left with unsold bonds.
Being a primary dealer is an expensive business, said one market participant at a large investment bank.
Banks will start to focus (now that) they have fewer resources. Does it really make sense for somebody to be in Spain or in Portugal?, this person said, speaking like others on condition of anonymity due to commercial sensitivity.
Banks used to buy bonds from government debt management agencies at a loss, in the hope of earning fees when governments sold bonds directly to investors via separate syndicated deals. These are auctions where a government sells bonds to investors through a designated syndicate of banks.
If banks do walk away from bond auctions, the loss of guaranteed buyers is likely to boost interest costs for cash-strapped countries in Europe, making life more difficult just as they need to plan to issue some 800 billion euros ($1,100 billion) of debt next year alone.
PRIMARY DEALERS EVERYWHERE
Many banks have ended up with primary dealer mandates from European governments -- the result of years of huge state borrowing and a widely held perception that there was no real risk in holding government bonds.
A small country like Austria, for instance, has primary dealer relationships with 24 banks.
But since Europe's debt crisis has brought the single currency to the brink of collapse, and three countries -- Greece, Ireland and Portugal -- were bailed out, the business is looking a lot less attractive.
Italy last month paid a record 6.5 percent to borrow six-month money, and its longer-term funding costs soared far above levels seen as sustainable.
And Germany saw a disastrous bond auction on November 23, with the central bank forced to pick up 39 percent of the intended volume, to prevent the sale from failing.
WARY OF GOVERNMENTS
Many primary dealers are taking measures to mitigate the risk from holding sovereign bonds on their books.
This can often lead to more market havoc.
The short-selling of government bonds ahead of an auction -- borrowing them and then selling them on in the hope of buying them back at a lower price -- is now a common practice, and tends to depress bond prices in the run-up to a sale.
In investment banking, talent tends to get sucked into the highest performing and most lucrative part of the business, which means that as sovereign auctions become less attractive and less lucrative, so their top traders are moved elsewhere.
That again can lead to more volatility, dampening investor appetite.
And banks are increasingly balking at signing derivative deals with governments, which use so-called collateralized swap agreements (CSA) as protection against market risk.
Governments traditionally used not to have to put up collateral for such deals, while banks did. But collateral is becoming scarce, and costlier, and banks are now reconsidering these so-called one-way collateral agreements.
It's extremely expensive to fund it. It dwarves any fees you might make on the swap, the first person said.
Portugal and Ireland have already been forced to put up collateral in swap agreements.
Most major U.S. investment banks and large European banks participate in the market, while dozens of smaller players may also have one or two mandates. BNP Paribas, Deutsche Bank and HSBC are the biggest players.
However, some argue that in the long run, banks will always want to sell debt for governments, because of the vast amounts they issue, and the reliability of their issuance calendars.
Do you know a lot of issuers that are committed to issue one year in advance at a certain date, a minimum amount whatever the market conditions are? said a second market participant, who works at a large European bank.
Still, acting as a primary dealer, and the market making duties that come with it typically costs a bank tens of millions of dollars a year -- anywhere between $20 million and $90 million, two people interviewed on the topic said.
Those who do not have a vested interested in continuing to develop their capital market franchise in Europe may effectively decide to back off, the second person said.
Because the market is extremely dangerous and therefore you need to have a strong commitment to this market to remain in this type of trouble, this person said.
(Additional reporting by Yeganeh Torbatil; Editing by Alexander Smith and Jodie Ginsberg)