IF YOU WERE thinking of throwing your hat into the ring to be a member of the Expert Group being set up by Niall Bohan, head of Capital Markets Union at the European Commission, on understanding and improving EU corporate bond market liquidity, it’s too late: the call for applications closed on August 5.
Bohan isn’t wasting any time. The workshop he hosted a couple of weeks ago in Brussels in pursuit of the CMU Action Plan gave market participants from across the industry, including regulators, an opportunity to air their thoughts on the state of play in corporate bond markets with a view to informing the policy debate. In a wide-ranging discussion, the old but still-fraught subject of liquidity took centre stage.
For all of its re-telling, the liquidity story never goes out of fashion and the song remains the same. But let’s face facts: liquidity as we knew it is gone. It’s hard to get executable prices and you can’t always deal quickly, certainly not in size. Leaving aside the (actually rather relevant) fact that corporate bond markets have always tended to be a bit like that, I say it’s time to change the song sheet and think about this issue from a very different perspective.
The time for pining for the old ways is over. The game has changed. The dealer market-making model as we knew it is dead. Bank proprietary trading and the single-name CDS market are to all intents and purposes dead. Hedge funds have retreated from accelerated highly-leveraged rapid-turnover strategies; new-issue allocation practices have changed and, according to the recent ICMA study on liquidity, credit repo is borderline dysfunctional.
We’re in a new paradigm. Time for innovative thinking. ICMA’s contention that “the market-making model is the optimal, and perhaps the only viable, source of true market liquidity” is a mightily big call in today’s evolving market. I’m not sure I’d want to be so bold. We’re not going back to a dealer-driven market-making liquidity anchor in my view. ICMA’s “coincidence of want” (probability of matching buyers and sellers of a specific bond at the same time) may currently be low but I say let’s move on from wishing back market-makers as capital-at-risk principals.
I doubt that continuing calls for capital give-ups for market-making have any legs. We’ve been down that track before and regulatory carve-outs from the capital framework for market-making were broadly rejected. Bohan’s Expert Group may push this cause hard but I’m sceptical.
WHERE WE’RE HEADED is an ecosystem in which sellside dealers act increasingly as partially or fully-matched agency brokers – and even then focused on a smaller client set and working a more specialised universe of bonds that suits their business model.
Dealers will increasingly feed off a market epicentre that will shift to accommodate the notion of a buyside-driven liquidity model. After all, a huge chunk of corporate debt sits in the vaults of large buyside shops (and increasingly at the ECB but that’s a story for another day) so that’s where you naturally have to look for solutions.
The constituency most concerned about the lack of liquidity is, surprisingly in my view, issuers. They’re concerned the “unsustainable disconnect between primary market stability and secondary market liquidity” that ICMA mentions will crimp their ability to raise capital, undermine price-discovery, increase refinancing risk, force them to pay significant NIPs, induce price volatility and create window markets.
The primary-secondary relationship is only unsustainable if you view it through the lens of historical “norms”. It’s impossible to know how long the abnormal environment we’re in today, driven by an abnormal set of monetary policy conditions, will be with us or what the new normal looks like. But I’d wager that a fully synchronised Old Skool primary-secondary accommodation is not part of that new normal.
If you need a catalyst to realise a redesign of the market architecture, that’s likely to be technology. Not more technology platforms; there are already too many sporting too many trading protocols. The market needs to consolidate and trade needs to be channelled through fewer platforms: otherwise all that’s happening is thin liquidity being fragmented even further.
As per the ICMA report, the next generation of platforms that focus on identifying and matching axes rather than quotes (in effect matching engines that scrape axe sheets in order to connect buyers and sellers), connecting all market participants and identifying pools of liquidity rather than trying to create it, sound promising. As the trade group points out, this is less about execution; that comes later either through dark pools or directly.
Also playing into this story is another reality: a handful of dealers dominate the landscape and that handful of dealers will deal (already are dealing) with an oligopoly of mega buyside clients. That’s where new-issue allocation has evolved; that’s where the wallet is. Investors will over time need to morph from being price-takers to being price-makers.
In an increasingly closed-circuit environment, I’m fascinated by the emergence (as touched on by ICMA) of internalised liquidity, where individual funds at big buyside firms make prices to each other to reduce reliance on dealers. I’m fascinated too by the notion of smaller buy-side firms outsourcing their trading to big buyside shops. The small guys have been squeezed out and starved of oxygen, so passing their orders and having them broked by mega firms for execution either via dealers or internalised liquidity seems a logical way forward.
While I wonder fleetingly if large institutional buyside shops won’t eventually become risk-takers and New Age market-makers, my exhortation for today is: let’s stop trying to turn the clock back. The capital markets are renowned for their innovation and drive to find solutions. In this case, looking in the rear-view mirror isn’t the answer.
