Trading awaits agency shift
Electronic platforms are queuing up to play their part in an anticipated revolution in corporate bond trading. But liquidity concerns might not be alleviated any time soon, as one newcomer collapsed just weeks into operation and buysiders are proving reluctant to shift from request-for-quote protocols.
Secondary corporate bond markets are on the cusp of the biggest upheaval in their history, as slashed dealer balance-sheet capacity spells the end of the traditional principal-based model. With 30-plus providers vying for a role in the new electronic infrastructure that aims to address the liquidity dearth, the market is ripe for change. But any shift towards an equity-like exchange trading model is proving slow to materialise.
New capital and leverage rules under Basel III mean that holding bond inventory has become a costly activity for banks. In mid-September, top US dealers held just US$19bn of corporate paper, a collapse of over 90% from the late 2007 peak of US$286bn, according to data from the Federal Reserve Bank of New York.
With the principal model battered, buyside firms – whose corporate bond holdings have surged alongside record issuance – fear a potential crunch if they are forced to sell in a stress scenario. For a buyside that is largely positioned one way, and with many funds offering daily liquidity, any major shock could see them struggle to offload assets at any price.
“Today, brokers and buyside firms need another way to trade,” said Seth Merrin, CEO of Liquidnet, an all-to-all electronic bond platform that went live in September. ”Under the old model, if you wanted to trade an illiquid bond, dealers would give a price for that. It would be at a much wider spread, but you could always get out of that bond.”
The solution, many believe, lies in electronic trading, which has long been the standard for ultra-efficient equity and foreign exchange markets.
UBS was one of the first to take a bet on an eventual shift to the agency model with the development PIN, its anonymous crossing network that facilitates interaction between retail and institutional order flow. With 2,600 liquidity sources and 800 active clients each month, the platform averages 950 trades a day across 11 currencies.
While more banks are developing agency-style platforms, the future is likely to lie in independent all-to-all venues. But it has not all been plain sailing, as the buyside is reluctant to break from traditional relationship-driven request-for-quote protocols.
Earlier this year, Bondcube became one of the first in a queue of start-up fixed income e-trading providers to test demand for all-to-all newcomers. Just three months into operation, it was forced to shut down when key backer Deutsche Boerse pulled funding from the struggling start-up.
While the platform attracted interest via on-screen price indications, its fate was sealed as executed volume stalled when buyers and sellers were unable to agree a price to trade.
“The problem is that everyone wants to sell on the offer and buy on the bid, and it’s not easy to negotiate if you don’t have a broker to meet in the middle,” said Bob Holland, senior product manager for Linedata, a global solutions firm providing trading and compliance services to fixed income investors as they link up to new venues.
“What the broker/dealer community provides is the management of the time mismatch to smooth the transition between buyers and sellers. If a seller has to wait or can’t find a buyer, they might have to sell something they don’t want to sell, or sell at an inferior price.”
While the move towards an electronic trading environment creates efficiencies for investors, it is no cure-all for a liquidity drought.
“There are a lot of initiatives around and it’s always good concentrating liquidity, but you can’t create it,” said Christophe Rivoire, global head of G10 flow rates at HSBC.
“To create liquidity you need people trading in different ways. Trying to concentrate liquidity in an aggregated manner to see what’s going on is a step forward, but if there’s nothing going on, you can’t help.”
The answer could lie with new liquidity providers, particularly buyside firms, which have replaced dealers as primary holders of corporate paper. Much of it is illiquid – more than 85% of corporate bond trades reflect around 15% of outstanding issues, participants note.
“Buyside-to-buyside liquidity is all well and good, but a fund manager’s fiduciary duty is to be a safe shepherd to client assets, not to make markets,” said Linedata’s Holland.
Interest is growing, albeit from a low base. Open Trading, a joint all-to-all venture between MarketAxess and BlackRock, now sees more than 60% of liquidity coming from non-dealers over the US platform, and 25% from non-dealers on the European version that went live earlier this year.
Credit Suisse Asset Management is taking an innovative approach with plans to launch a long/short fixed income fund that will ultimately see it take the role of a liquidity provider. By posting liquidity, the firm aims to monetise the market-making strategy and wrap it into a fund to pass on to investors.
“In three to five years time, we believe there will be a big shift towards electronic platforms and the buyside will compensate a part of that liquidity,” said Michel Degen, head of core and specialised fixed income at Credit Suisse’s asset management business. “The shift of investment bankers to asset managers is already happening.”
Crucially, the Credit Suisse fund stands to gain from any widening in spreads that accompanies a further decline in liquidity. The evidence, however, suggests that the link between trading activity and price-based liquidity measures such as bid/offer spreads is not obvious.
Research from the Federal Reserve Bank of New York shows that bid/offer spreads and price impact measures in the US corporate bond market remain low by historic standards. Bid/offers are currently below 1% of par – slightly below pre-crisis levels and a huge decline from 2009’s post crisis highs of around 3%.
Similarly, price impact is currently around 0.5% per US$100m of bonds traded, compared to around 1% pre-crisis.
“This is a remarkable finding, given that dealer ownership of corporate bonds has declined markedly as dealers have shifted from a “principal” to an “agency” model of trading,” noted Tobias Adrian, senior vice president in the Federal Reserve Bank of New York’s Research and Statistics Group.
“These findings suggest a shift in market structure, in which liquidity provision is not exclusively provided by dealers but also by other market participants, including hedge funds and high-frequency-trading firms.”
Bondcube’s failure has not deterred its many competitors. Just 18% of corporate bond trading takes place electronically and many expect the entire market to make the shift in the coming years.
Algomi, a start-up firm that aims to facilitate liquidity by aggregating information on corporate bond holdings and trading history, recently signed its 100th buyside customer to the Honeycomb network, which also includes 11 dealer firms. The technology allows investment firms to see which dealers can facilitate illiquid corporate bond trades without disturbing the markets and having the price move against them.
Anonymous all-to-all platform, Liquidnet, believes it has the credentials to succeed where Bondcube failed, in large part due to its position as an established player in the equity dark pool space, where it operates with around 800 clients.
“We started from day one with 120 clients connected,” said Merrin. ”Getting to critical mass is the number one issue that all start-up platforms face. One benefit we have is that we’re already broker-approved and clients are already linked up from our equities business. Without this, the time that it takes to on-board new clients could stretch to months or years.”
Unlike other venues that allow participants to post indicative prices, Liquidnet offers aggregated liquidity, which brings the platform closer in line with equity markets than its larger bond trading rivals.
With greater transparency comes greater information leakage – a potential death knell for liquidity – but the new platform protects buyside liquidity via a separate protocol for the sellside community, reducing what dealers can see. The platform has so far attracted interest from seven dealers.
“The platform helps all market participants to connect the dots and source liquidity from each other in a way that doesn’t give away information until they actually come together to do the trade,” said Constantinos Antoniades, head of fixed income at Liquidnet.
With market participants looking to connect to only a handful of new platforms, given the huge volume of legal and compliance work involved, the clock is ticking for those yet to launch. Singapore’s SGX is planning to go live with its bond trading platform before the end of 2015, and is already generating interest from potential clients as it offers regional specialism and operates in a less crowded market, Linedata’s Holland notes.
“By June of next year, we’ll have a good idea of which providers will make it through, so we’re getting to the point where you need to be up and running to be one that makes it,” said Holland.
Established players such as Bloomberg, MarketAxess and Tradeweb have yet to make a full shift towards the click-to-trade model, instead offering what many view as an ultra-fast RFQ model that gives liquidity providers a last look on pricing before they agree to trade.
“Most incumbents effectively take a voice trade and turn it into an electronic trade, which brings efficiencies to the client. But what they don’t do is aggregate liquidity,” said Merrin. ”Today, dark pools only exist in equity markets, but what we’re offering is the closest to equity trading, where all participants can meet to trade in large size,”
Established players are finding traction with the hybrid model. MarketAxess, for example, reported a 32% increase in its electronic corporate bond volumes for the second quarter.
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