SINGAPORE IS ABOUT to establish a dark pool for bond trading under the auspices of the Singapore Exchange, apparently in response to feedback from SGX traders and participants.
That’s a bold move, since dark pools have a less-than-pristine reputation – and a rather sinister name - and the anti-banker fraternity would no doubt like to latch onto it as more evidence of the demonic practice of the professional financial community, albeit without fully understanding the modus operandi.
So let’s remind ourselves that dark pools are private trading arenas for financial instruments – principally equities and bonds – where size and price are not flagged and which are most commonly operated by banks. The aim of a dark pool is to minimise market impact by allowing the side a potential trader is on, plus the outcome of the trade, to remain hidden.
This is perceived as invaluable, particularly in the illiquid arena of Asia’s high-yield bond market, where the knowledge that there is a big block seller out there can have a huge impact on quoted pricing.
Looking back to my days as a bond salesman in London more than two decades ago I recall investors who held large chunks of a high-yield position – more often than not the “stuffees” from a mispriced new issue that had been allowed to season and still failed to perform – sitting in terror at the thought their selling interest would reach the ears of the brokers.
Invariably it did. (“There’s a seller of thirty million of the Dogsville 99s. He’s looking at plus 230 but I reckon it’s closer to plus 250.”) The spread was soon some way north of the seller’s pricing ambition as the position was jawboned around the market. The dark pool is designed to avoid this outcome, and it seems to work.
Dark pool trading in US securities has grown by around 50% over the past three years and accounts for just under half of all “non-displayed” OTC trades. Indeed dark pool stock trading volume in the US narrowly exceeds the quoted volume on the New York Stock Exchange. Europe and Australia have also embraced the concept.
So rather than providing a bespoke solution for the stated interest of its members, Singapore’s SGX is merely getting on the global bandwagon. But is the dark pool a welcome feature of the electronic, hyper-connected cyber age or could it be, at least as far as fixed income is concerned, a symptom of something rather less auspicious?
I’m thinking here of the Volcker rule and its attempt to rein in proprietary trading by the banks. Balance sheet exposure to vast secondary debt positions was seen by former Fed governor Paul Volcker and the architects of the Dodd-Frank Act as an axiomatic cause of the global financial crisis.
Singapore’s SGX is merely getting on the global bandwagon
I’M NOT CONVINCED that their edicts, issued in the years following the GFC, are fully enforceable, and I’m sure banks from San Francisco to Shanghai regularly transgress when it comes to taking positions in debt securities. But nevertheless there’s no doubt the presence of banks in the secondary bond markets has shrunk significantly over the past few years, and looks set to contract further as full Basel III compliance is put in place.
In some sense though, we’ve been here before. During the 2008 crisis, bond market liquidity dried up as banks slashed their balance sheets. Bid/offer spreads on dollar paper in Asia at the sub-investment grade level widened to an average of anything between five and eight points.
And that spread became an exciting proposition for those who thought they could get inside it by matching buyer with seller and taking rather a nice turn for themselves in the process.
One such establishment was Amias Berman, the brainchild of two former superstars at the old Salomon Brothers, who set up shop in Hong Kong as the crisis was panning out in the hope of finding the alchemy of the client-to-client cross.
The company was bought out a few years back and still operates as an independent principal fixed income firm, but the days of the proverbial “spread you could drive a bus through” have gone – perhaps in part down to the dark pool phenomenon.
STILL, THE TRUTH is that secondary bond market liquidity has been in secular decline over the past seven years-odd, particularly in the Asian offshore dollar markets.
There are reasons over and above regulatory constriction and banks’ balance sheet shrinkage, including a buy-to-hold culture in Asia and a surfeit of primary issuance that has relegated secondary seasoned paper to the back burner. In this context regional DCM bankers will hope that the secular decline in liquidity has run its course.
But I suspect should the Fed begin to normalise rates at its next meeting in December, liquidity will take yet another hit, as funding short-term bond positions on repo becomes more expensive.
It begins to look as though not only is the dark pool here to stay, but that it will become indispensable. And all the more so when the long overdue seismic shift upwards in Asian default rates begins to unfold.
